Today's post is going to begin just as did the post from last week, with two exceptions: the date and the actual number.
The latest banking week at the Federal Reserve ended on New Year's Eve, December 31. As usual during the holiday season, several operational factors impacted the Federal Reserve's actions, but the net impact was to reduce reserves in the banking system by $232 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 the year.
However, these are unusual times.
Since the reserve balances with Federal Reserve banks peaked on October 15, 2014, and since the Federal Reserve ceased its tapering operations, the Fed has reduced reserves in the banking system by $443 billion.
To put this number into perspective, it is important to note that the total assets on the Fed's balance sheet in August 2007 were only about $900 billion.
The biggest change in the Fed's balance sheet last week was a $194 billion increase in reverse repurchase agreements with "others," primarily government securities dealers. This has been the major tool used by the Fed to reduce reserves in the banking system.
The most important reason for using these repurchase agreements, as I have noted in previous "exit" posts, is that they only represent a "temporary" removal of reserves from banks.
The Federal Reserve is not ready, at this time, to actually begin selling securities from its portfolio, because of its concern about removing reserves from the banking system that the banks themselves don't want removed. Thus, the use of repurchase agreements allows the Fed to remove the reserves from the banking system, but can let these repurchase agreements run off in the short run if there appears to be any desire by banks to hang onto the reserves.
Since October 15, reverse repurchase agreements have increased by almost $250 billion.
The other "tool" the Fed has used since this date has been term deposits, which the banks have held at the Fed, but it has allowed all these deposits to expire in recent weeks.
The two other major factors impacting reserve balances with Federal Reserve banks are currency in circulation and an increase in deposits in the general account of the United States Treasury. Both of these accounts usually increase at this time due to seasonal effects.
In terms of currency in circulation, it usually flows out of the banking system and into the hands of consumers during this season to support holiday purchases. The Federal Reserve usually supports this outflow by temporarily adding reserves to the banking system to help keep banks liquid.
Since October 15, the currency in circulation has increased by almost $47 billion.
After the first of January, currency usually flows back into the banking system, and the Fed then removes the temporary reserves it added during the holiday. As noted, this year, the Federal Reserve actually removed reserves from the banking system.
The other year-end phenomenon the banks face is a seasonal flow of Treasury funds from the banks to the Treasury's General Account at the Federal Reserve. Again, the Fed usually offsets this flow by adding reserves to the banking system. This year, since October 15, the General Account has risen by slightly more than $134 billion. The Fed did not offset the flow of funds this year by adding reserves to the banking system.
After the first of the year, these funds usually flow back into the banking system, and the Treasury spends the money. And the Fed then removes the reserves just added, in an effort to keep the banking system stable.
The money markets remained calm this year, and the effective federal funds rate remained constant during the month of December, averaging 13 basis points every day... except for December 31, when the effective federal funds rate averaged only 6 basis points... certainly not an indication of a "tight" banking system.
The interesting things to watch in January will what happens when the currency in circulation begins to return to the banking system and when the Treasury spends the funds in the General Account. Both of these events will put the reserves back into the banking system.
In the past, the Federal Reserve has "offset" these funds flowing back into the banking system by removing the reserves it "temporarily" injected into the banks. Since the Fed did not inject these reserves this year, the question is, will it still remove the reserves now flowing back into the banking system?
It certainly seems as if it is in a position to do this. Hypothetically, if the Fed removes all the reserves that seasonally flow back into the banking system, that would mean that the banking system would still have $443 billion lesser in reserve balances than it did on October 15, 2014, and this, I believe, would put the Federal Reserve in as good a place as we could have hoped for at this time in its "exit" strategy.
The Fed would be in a good place, because it would have started to reduce the "excess" liquidity in the banking system, something I have argued that needed to be done before it could actually cause short-term interest rates to rise at some time during 2015.
The other thing that is needed for short-term interest rates to rise is a strong economy that would cause loan demand to increase, but that is another story.
Successfully reaching a position where bank reserves have declined by $443 billion also puts the Fed in a position where it could begin to reduce its securities portfolio. The reduction in reserve balances, so far, has been through the use of "temporary" tools like repurchase agreements and term deposits.
To seriously shrink its balance sheet, the Fed is going to have to move from the "temporary" tools to the standard tools of monetary policy. That is, the Fed, at some time this year, will have to begin to either let securities "run off" its balance sheet or engage in open-market sales of its securities. This latter action will only be done "gently" at first, so as to not disrupt bank reserve positions.
Let me just close by saying that I believe that the Fed's actions since October 15 have been "spot-on."
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