This Indicator Is Saying No Rate Hike

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While a mere 1/4 point increase in interest rates may not have an impact on the real economy, it would greatly impact financial markets.

Pay attention to what the Fed is doing rather than what it is saying.

The increase in the level of excess reserves in the banking system suggests there will be no interest rate increase.

We all know the Fed talks a good game when it comes to the economy. Fed officials sound knowledgeable when they discuss the economic fundamentals, and they sound sincere when they give us their forecasts for growth and inflation. Yet as the years have passed since the Great Recession it is becoming more apparent than ever that they really don't know what they are talking about. This makes it all the more difficult to determine when they will raise short-term interest rates.

Will they raise rates because they honestly believe that the economy is strengthening, or will they raise rates in the hope that households and businesses will believe this to be so, and respond accordingly by increasing spending and capital expenditures, respectively? Will they hold off on a rate increase because they fear that the economy is too weak to handle a tightening of policy, or will they hold off because they fear a stock and bond market sell-off might reverse the wealth effect and negatively impact the rate of economic growth? All we can do is speculate at this point.

While a mere ¼ point increase in short-term interest rates might not have much impact at all on the real economy, it would have a significant impact on financial markets. Consider the nosedive that the S&P 500 (NYSEARCA:SPY) took shortly after the first interest-rate increase last December. While there were other factors involved at that time, the end of zero-interest-rate policy was a significant one. Therefore, it would be helpful to have some idea of when the next interest-rate increase is approaching, so that we could plan our investment strategy accordingly. One indicator that I think might give us a clue as to what the Fed is planning on doing, as opposed to what it is saying it will do, is the change in the level of excess reserves held by banks.

As you can see in the chart below, the level of excess reserves in the banking system fell measurably in the weeks leading up to the first interest-rate increase. Excess reserves declined from approximately $2.6 trillion to $2.4 trillion, or $200 billion, in advance of the Fed's decision to raise short-term rates by ¼ point in December 2015. The Fed used its reverse repurchase agreement facility (reverse repos) to drain excess reserves by exchanging Treasury securities on its balance sheet for the reserves held by banks, thereby reducing liquidity in the financial system, which was consistent with a tighter monetary policy.

If we look at the past several weeks, the level of excess reserves has increased by approximately $100 billion. This is not indicative of tighter monetary policy. It seems to me that if the Fed were preparing to raise short-term interest rates, we would be seeing a more significant decline in excess reserves. We will find out later today whether this indicator has any value. I am still of the opinion that the Fed will not raise interest rates this year.

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.

Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.