Federal Reserve Exit Watch: Number 4

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Includes: DIA, IWM, QQQ, SPY
by: John M. Mason

Summary

The Federal Reserve continues to reduce reserve balances in the banking system in a most, unseasonal way.

Still little, to no, pressure in the money markets to rise in the face of Fed reduced reserve balances.

We will need to get out of the holiday season to really see how the Fed is going to reduce bank reserves to the point that short term rates rise.

The latest banking week at the Federal Reserve ended on Christmas Eve, December 24. As usual during the holiday season, several operational factors impacted Federal Reserve actions, but the net impact was to reduce reserves in the banking system by $130 billion.

This reduction in reserve balances is highly unusual during the holiday season, since, historically, the Federal Reserve is a supplier of reserve balances during this time of year.

However, these are unusual times.

Since, October 15, 2014, the Federal Reserve has removed just over $210 billion in reserve balances with Federal Reserve banks. I use the October 15 figures because that is the date at which reserve balances with Federal Reserve banks peaked even though the Fed's tapering operations continued until the end of the month.

Second, I highlight the reduction of $210 billion because in August 2007, before the Great Recession began and before the Federal Reserve started opening the spigots and began to flood the banking system with reserves, the balance sheet of the Fed only amounted to about $900 billion in assets. I think we need to keep these numbers in mind so that we can comprehend, a little bit more, the magnitude of the task that lies before the Fed.

The securities held by the Fed increased by $5.4 billion during the week, all of the increase coming in the Fed's holding of Mortgage Backed Securities. Since October 15, the Fed's portfolio of Mortgage Backed Securities has increased by $38 billion.

Factors absorbing reserves from the banking system, however, rose by almost $137 billion.

Seasonally, currency in circulation rose by almost $12 billion and this removes reserves from the banking system.

But, Reverse Repurchase Agreements rose by $71 billion. This has been a primary tool the Fed has used to reduce banking reserves since October 15. As I have noted in other "exit watch" posts, the Fed is only removing reserves "temporarily" from the banking system so as not to reduce reserves beyond what the banking system is comfortable with. Reverse repurchase agreements with "others" totaled $203 billion on December 24.

This "cautious" approach to the removal of reserves is aimed at avoiding disruptions to commercial bank operations that might cause problems.

During this time of "exit", the Federal Reserve has also solicited deposits from banks to be held in "term" deposits. As noted in my last "exit watch" post, the Fed allowed all these accounts to run off by December 17. Term deposits had reached $402 billion at one time since October 15.

Two other factors caused bank reserve balances to decline in the past banking week. The first was a rise in the Treasury's General Account balance. This is an operational factor that can have major short-run impacts on bank reserves. During the past banking week, the General Account rose by $6.6 billion.

The other operational factor that reduced bank reserves this past week was a $50 billion increase in Foreign Official deposits at the Federal Reserve. Again, this is something that happens from time-to-time and the Fed has to account for it in its over-all impact on bank reserves.

Again, there appeared to be no major pressure building in the money market. The Effective Federal Funds rate for the week averaged 0.13 percent all week, which was where it had been trading in recent weeks.

So, the Federal Reserve appears to be continuing to reduce the reserves of the banking system held with Federal Reserve banks. Again, I point out that this is unusual behavior during the holiday season for the Fed generally responds to the seasonal pressures on the banking system, like the outflow of currency into the hands of consumers, by adding reserves.

This year, with all the excess reserves on hand, the Fed has been able to reduce reserve balances, a sign that the banking system has ample reserves to handle seasonal outflows of funds and any loan demands that might be present.

What we need to watch for after January 1, 2015 is how the Fed handles, what is usually a seasonal return of funds to the banking system, a process that usually causes the Fed to remove the returning reserves so as to absorb all the excess liquidity returning to the banks. How will the Fed handle these flows this year, especially since it seems to want to get reserves down to a level that the money markets start to "tighten up" a bit. As I have noted before, this needs to happen before the Fed can achieve a rise in short-term interest rates, which it seems to want to do…sometime in the late spring or summer.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.