Federal Reserve Watch: The Fed Moves On

by: John M. Mason


As expected, officials at the Federal Reserve did not move the policy rate of interest this past week as FOMC members reduced their forecasts for the future.

Given the weaker future these officials see, they are projecting rising interest rates, but the size of the increases and the timing of the increases were not presented.

The Fed's balance sheet reflects this backing off on an imminent interest rate increase and shows the Fed taking a fairly easy stance with respect to bank excess reserves.

Well, the Federal Reserve did what it was expected to do… it didn't do anything.

At the Federal Open Market Committee (FOMC) meeting this past week, the voting members of the FOMC voted unanimously to not change the Fed's policy interest rate range.

A unanimous vote had not been achieved at recent meetings.

The recent data from the labor market certainly had an impact on the thinking of Fed officials.

But, they seemed to have been moving in that direction anyhow, and this was certainly reflected in the projections of board members released after the FOMC meeting ended.

Of particular note in these numbers was the expected real growth of the United States economy over the next few years.

The economy is only expected to grow at a 2.0 percent rate this year. But, the economy is not expected to do any better in 2017 and 2018… and longer.

This is no better than the economy has grown over the seven years… ending June 30, 2016… of the current economic recovery. That is, the compound rate of growth of the real economy since the end of the Great Recession is just over 2.0 percent.

That is, Fed officials are basically saying the US economy has run out of gas.

Still, inflation is supposed to pick up over the next few years, something that Fed officials, particularly Vice Chair Stanley Fischer, has argued over the past few years.

In 2018, Fed officials see the inflation rate in the US returning to its target level of 2.0 percent.

In other words, the feeling is that the general level of prices will return to a level achieved earlier in the economic recovery before oil prices and other commodity prices fell in world markets. These prices are supposed to bounce back a little and this will take the price index used by Fed officials back to the 2.0 rate.

Note, that inflation in 2016 is expected to be 1.6 percent.

As the Federal Reserve backed off on moving interest rates, they also "tamed down" their "forward guidance" as to the future of interest rate increases.

The effective federal funds rate is expected by Fed officials to end the year around 0.9 percent. Right now, the effective federal funds rate is around 0.4 percent… the actual number reported by the Fed is 0.37 percent for June 13, 14, and 15, the latest data available.

This basically implies that this rate will rise by 50 basis points by the end of the year which would be consistent with the Fed still making two changes to the policy rate, each change being only 0.25 basis points. There is nothing different here from the information the Fed gave us in late 2015. The only thing that has changed is that emphasis has been taken off of timing. That is, Fed officials expect two increases in the policy rate this year, they have just become more ambiguous about when the increases might occur.

For 2017, Fed officials see the fed funds rate rising to 1.6 percent. This implies that the fate would have to move by about 70 basis points, and this could include three Fed actions next year. Again, there is no information about when the changes might take place.

Then, we notice that in 2018, the federal funds rate is to rise to 2.4 percent and then "in the longer run" the rate will rise to 3.0 percent. Thus, the Fed is saying, expect rate to rise continuously over the next few years, but the changes will be neither dramatic, nor will they be predictable.

As readers of this post know, I have given a lot of attention to how the Federal Reserve has maneuvered its balance sheet over the past nine months or so to try and determine whether or not the Fed was moving to reduce reserves before it made an increase in its policy rate.

From October 2015 until the Fed moved to raise its policy rate in December, there was a definite move on the part of the Fed to reduce the reserve balances of commercial banks, a proxy for excess reserves, with Federal Reserve banks.

In March 2016, it seemed as if the Fed was again reducing reserve balances so as to prepare the banks for another rise in the policy rate. In June, after the labor market statistics referred to above were released, the Fed began to back off. This is why I was very sure the FOMC was not going to move on interest rates at its meeting in June.

Now, the pressure is off. What is going on with the Fed's balance sheet?

Well, except for the past banking week, the Fed has been providing reserve balances, increasing excess reserves, in the banking system.

Since the first week in May, May 4th to be exact, through June 15, the Fed has overseen bank reserves grow by $21.5 billion. In the second quarter of 2016, from March 30 through June 15, reserve balances at the Fed have grown by almost $70.0 billion.

For the first half of the year, from December 30, 2015 through June 15, reserve balances have grown by almost $200.0 billion. In looking at this number, remember that the Fed had just raised its policy rate in the middle of December and in January of this year, markets were extremely volatile and needed liquidity in order to smooth out market adjustments.

Bottom line, the Federal Reserve has overseen a fairly generous growth in reserve balances since the first of the year. Overall, this is not indicative of any longer-term goals of the Fed to drain excess reserves from the banking system.

It can be noted that at their peak, reserve balances with Federal Reserve banks totaled $2,820.7 billion on October 15, 2014. This was right around the time that the Federal Reserve ended its third round of quantitative easing.

On June 15, 2016, reserve balances with Federal Reserve banks totaled only $2,404.9 billion, $415.8 billion less than their total at their peak. So, the Fed has watched as a large number of reserves have left the banking system.

To put this number into perspective, on September 26, 2007, before the Great Recession hit, the total… read again… the total assets held by the Federal Reserve totaled only $900.5 billion. Thus, the decline in bank reserves since the end of quantitative easing III, amounted to roughly 46 percent of what the total assets of the Fed were before that Great Recession hit.

So, the Fed moves on. One thing we see is that the Fed seems to be widening its scope of what it incorporates into its decision making process. Certainly, what is going on in China cannot be ignored as with other events taking place in the world. The Fed does not have an easy job!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.