Federal Reserve Exit Strategy: Number 8

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


Over the past two weeks the Federal Reserve continued to reduce commercial bank reserve balances with Federal Reserve banks.

To do this the Fed has increased its use of repurchase agreements and has also benefited from seasonal factors that have reduced reserve balances.

The money markets continue to be very calm with the effective federal funds rate remaining roughly constant.

Well, I missed a week of writing on the Fed…I was watching my grandsons play hockey…they won 5 and lost none over the weekend…and during that week the Federal Reserve produced a sizable increase in their repurchase agreements.

The account is a liability account because the Fed is selling securities under an agreement to repurchase them in several days, but the account is listed as if the transaction came from the securities dealer. The account is called "Reverse Repurchase Agreements."

From January 14 to January 21, the Federal Reserve increased this account by more than $73 billion. It added 3.6 billion in the week ending January 28, so that the total for the two weeks amounted to almost $76 billion.

Since October 15, 2014, the date when Reserve Balances with Federal Reserve banks…a proxy for excess reserves…peaked at $2.8 trillion, the Federal Reserve has been using repurchase agreements and term deposits at Federal Reserve banks to lower the amount of excess reserves in the banking system.

It is using these short-term instruments to remove reserves so that if any disruption occurs in the money markets because of the withdrawals, the Fed can quickly reverse the transactions so as to avoid any unwanted pressure.

The Federal Reserve, at some time this year, wants to raise short-term interest rates. I believe that this would be a very difficult task when there are so many excess reserves in the banking system. I believe that the Federal Reserve will slowly reduce the excess reserves in the banking system…as long as these actions do not cause problems in the banking system…so that it, the Fed, can have more control over short-term interest rates.

The federal funds rate is as low as it is because there is a lack of demand coming from the banking industry for funds that can serve as reserve requirements. Because of this lack of demand the effective federal funds rate remains quite low.

The effective federal funds rate was 0.12 percent on January 28, 0.11 percent on January 27, and 0.12 percent on January 26. The previous week the rate averaged 0.13 percent, roughly in line with the weekly averages for the previous six weeks. On October 15, 2014, the week that reserve balances with Federal Reserve banks peaked, the effective federal funds rate averaged 0.9 percent.

Since October 15, 2014, reserve balances with Federal Reserve banks has declined by almost $160 billion.

Besides the increase in reverse repurchase agreements, there have been some "operational" or "seasonal" factors that have also contributed to the decline reserve balances. For example, currency in circulation is almost $34 billion higher on January 28 than it was on October 15. The reason for this increase was the holiday season when people draw money out of the banks to handle smaller purchases. Over the past several weeks, currency in circulation has been declining as cash trickles back into the banking system once the holiday season ends.

Another operating factor that is seasonal in nature is the pick up in tax funds coming into the General Account of the US Treasury department, which is held at the Fed. Since October 15, this account has risen by about $93 billion and this takes reserves out of the banking system. Almost $39 billion has flowed into this account in just the last two weeks.

What becomes tricky for the Fed is the fact that these Treasury funds will be paid out in the near future putting reserves back into the banking system. The trick for the Fed is, how does it manage these seasonal inflows and outflows and continue on the policy path it has laid down for itself.

On the other side of the ledger, the Federal Reserve has added $28.6 billion to its securities portfolio since October 15. Most of the net purchases have been in mortgage-backed securities and this account has risen by $25.2 billion.

The Fed continues to buy mortgage-backed securities, it added almost $12.0 billion to its portfolio in the week ended January 28.

The obvious reason for this activity is to keep the market for mortgage-backed securities going so as to encourage the housing market.

As I have stated before, this is going to be an interesting year for the Federal Reserve and this is as good a reason as any to keep our eyes on what the Fed is doing.

The cross-currents going on in the world are creating many different things to watch…the decline in oil prices…the rising strength of the US dollar…the low level of inflation…the efforts in other nations to reduce the value of their currencies…the problems in the Middle East…the problems in the Ukraine…and so on and so forth.

I do believe that officials at the Federal Reserve would like to see the volume of reserve balances with Federal Reserve banks fall. I feel that if the Fed is to have any hope exerting some control over short-term interest rates later this year, it must get these reserve balances down. But, it must reduce these reserves in a very gentle way so as not to disturb the positions of commercial banks. But, there is so much else going on that it is going to be hard to know exactly what it is that the Fed is signaling us. Hang on!

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.

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