Federal Reserve Watch: Fed Continues To Remove Reserves Preparing For December Rate Increase

by: John M. Mason

Summary

Two years ago, the Federal Reserve ended it's third round of quantitative easing and since then, the Fed has overseen a reduction in bank excess reserves of $715 billion.

The Federal Reserve has not used open market operations to achieve this reduction; the decline has resulted from the use of the Treasury's General Account, reverse repos, and currency outflows.

The Fed continues to remove reserves from the banking system in preparation for a December increase in its policy rate of interest.

This past banking week marked the anniversary of the end of round three of the Federal Reserve's Quantitative Easing.

Over this two year period, the Federal Reserve has overseen a reduction of reserve balances with Federal Reserve Banks, a proxy for excess reserves, of $715 billion.

Reserve balances with Federal Reserve Banks still totals $4.513 trillion on October 19, 2016.

Note that before the recent financial crisis began in the fall of 2007, the total balance sheet of the Federal Reserve only totaled slightly more than $900 billion.

And, the Federal Reserve has completed all this reduction in reserve balances by the use of tools on the liability side of its balance sheet. That is, there have been no open market transactions to achieve the reduction in reserve balances. Total Factors Supplying Reserve Funds show a $4.4 billion decrease over the past two years.

Total Factors Absorbing Reserve Funds has risen by $710.5 billion. These factors have reduced reserve balances held by commercial banks.

The primary tool used to reduce reserve balances has actually been the deposits the US Treasury Department holds with Federal Reserve Banks in the Treasury's General Account.

Since October 15, 2014, these General Account balances have contributed $308 billion to reduction in reserve balances.

And, note, on October 19, 2016, a new historic high was reached in these deposits as the total of the accounts rose to $453 billion. On October 15, 2014, these balances totaled $101 billion and just before the financial crisis began in the fall of 2007, these balances were only about $5 billion.

It is important to recognize that one of the most important tools that the Federal Government has used to manipulate the reserves in the banking system during this time has been the US Treasury's primary operating account.

Before October 2014, tax revenues were initially collected in Treasury tax and loan accounts. So, when taxes were originally paid, the money was transferred from the tax-payers account to these T&L accounts and this did not disrupt the reserve balances that were held in the commercial banking system.

As the US Treasury began to pay bills out of it's General Account at the Fed, the Treasury would draw money into its General Account from the T&L accounts at the bank and the as the Treasury's checks were deposited into the banking system, these funds would replace the funds leaving the banking system for the General Account so that reserve balances were minimally disrupted.

No more. The Treasury's General Account has become a major tool used by the Federal Reserve to withdraw reserves from the banking system. As mentioned above, the total of the account on October 19, 2016 reached a new historic high.

The second major tool used by the Fed to reduce reserve balances in the banking system was Reverse Repurchase Agreements. Since October 15, 2014, the amount of reverse repurchase agreements on the Fed's balance sheet rose by $210 billion.

This has been the most flexible tool used by the Fed to manage reserve balances. In normal times, the account is used to deal with temporary shifts in reserve balances and usually only stay on the books for a very short period of time. Now, they have been used for more "permanent" reductions in reserve balances. The account is also now near historic highs.

The final major source of money moving out of reserve balances comes from Currency in Circulation. That is, when currency leaves the commercial banking system, reserves also leave the banking system.

In more normal times, the Federal Reserve offsets these movements and offsets the movement of cash into the hands of the public by open market operations.

Here again the Federal Reserve is using this movement of cash as a tool to reduce reserves in the commercial banking system by not replacing the funds, once the cash is taken out of the banks.

Currency in Circulation, over the past two years has resulted in another $181 billion of reserves leaving the banking system.

The Fed has now instituted another tool to manage commercial bank reserve positions, a tool that has been used to manage more temporary movements in funds. This is the Term Deposit account.

In fact, the Federal Reserve just awarded, on October 20, 2016, $48.6 billion in term deposits, which will reduce reserves in the commercial banking system.

One can guess that the Fed might be preparing for a reduction in the Treasury's General Account from the historic highs reached this past week.

Over the past several weeks the Federal Reserve has appeared to begin to prepare the banking system for an increase in its policy rate of interest at its December meeting. Last year the Fed reduced reserves in the fall period before it raised its policy rate at the December 2015 meeting.

Since September 14, 2016, the Fed has overseen a reduction in reserve balances with Federal Reserve Banks. This reduction of reserves has continued into this week, led by an increase in the Treasury's General Account and by an increase in reverse repurchase agreements.

With the historic highs in the Treasury's General Account it is to be expected that a decline will take place in the near future. Thus, is seems reasonable to assume that the awarding of Term Deposits is an effort by the Fed to cover an outflow of Treasury funds from the General Account and maintain the reduction in reserve balances that was begun in September.

There is one concern of mine that has been growing over the past several months.

The Treasury's General Account has reached historic levels and one wonders just how much further this account can be increased.

Also, this past year the use reverse repurchase agreements has reached historic highs and the use of this tool has been adapted to "permanent" reductions in reserve balances. Just how much further can the Fed continue to use this tool in this way?

In other words, how much further can the Federal Reserve go in managing the reduction of reserve balances in the banking system without resorting to its more traditional tool of open market operations? I don't know how much farther the Fed can go without selling securities.

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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.