Federal Reserve Watch: Bank Excess Reserve Continues To Decline

by: John M. Mason

Summary

The Federal Reserve continues to oversee a decline in commercial bank reserve balances with Federal Reserve banks, apparently in preparation for an increase in its policy rate in December.

Again, the movement of US Treasury balances seems to play a major role in the decline in bank reserves.

Since the end of Quantitative Easing III, the Fed has overseen a $756 billion drop in bank reserves, again most of this coming from the movement of US Treasury deposits.

The Federal Reserve continues to oversee a decline in commercial banks' reserve balances with Federal Reserve banks, a proxy for excess reserves in the banking system.

In the banking week ending October 26, 2016, reserve balances with Federal Reserve banks dropped almost $41.0 billion.

These excess reserve balances have dropped by more than $284.0 billion since the banking week ending September 14, 2016. Since this latter date, the direction of movement of reserve balances has been downward.

I have argued that the officials at the Fed are preparing banks and the financial markets for an increase in its policy rate of interest at the December meeting of the Federal Open Market Committee.

Last year, the Fed did something similar, reducing these excess reserves before it raised its policy rate at the December 2015 meeting of the FOMC

The range for the Federal Funds rate is now 25 basis points to 50 basis points. In the futures markets, participants are indicating that the probability of a December increase of 25 basis points to this range is about 75 percent. The effective Federal Funds rate has been at 41 basis points for several weeks.

Of the $41.0 billion decrease in reserve balances in the last banking week, it appears as if the federal government was associated with almost $26.0 billion. The US Treasury's General Account rose by almost $11.0 billion and another account that includes government deposits rose by slightly more than $15.0 billion. Note that the amount of funds in the Treasury's General Account, $420.0 is at an all-time high!

The rest of the decrease in reserve balances came as the Fed allowed almost $15.0 billion of mortgage-backed securities from its portfolio to run off.

The interesting thing that took place last week was the Fed's acceptance of $48.6 billion in 7-day Term Deposits. Term deposits have been another tool the Fed has used to manage reserve positions, given that it is not using open market operations to manage its securities portfolio.

This use of term deposits can be matched up with a decline in the Fed's reverse repurchase agreements account that is the trading account for discretionary market operations. This account fell by $49.7 billion last week. The reverse repurchase agreement account with "Others" was at an all-time high of about $192.0 billion in the previous week.

It should be noted that reverse repurchase agreements with "Foreign official and international accounts" has been at historical highs beginning February 2016 and have varied around $240.0 billion since then.

Obviously, the total of $432.0 billion in temporary reserve removal using reverse repurchase agreements is at an all-time high.

One further note: last week I wrote that we were at the two-year anniversary of the ending of Quantitative Easing III. My time passes quickly….

When QE III ended in October 2014, reserve balances with Federal Reserve banks totaled $2.821 trillion.

These "excess reserves" in the banking system have dropped by $756.0 billion since the middle of October 2014.

Note that the total assets on the balance sheet of the Federal Reserve was only $911.0 billion in late August 2007, just before the financial crisis began.

The biggest contributor to this decline: The increase in deposits in the US Treasury's General Account. This account is now $319 billion above the level it was in mid-October 2014.

The US Treasury has made the largest contribution to the reduction in reserve balances since QE III ended by drawing its funds from the commercial banking system!

The next biggest contributor: currency in circulation. People have taken $181.0 billion in cash from the banking system! In more normal times, the Federal Reserve usually offsets these withdrawals from the banking system through open market operations.

The third biggest contributor: reverse repurchase agreements. Finally, we get to one of the Fed's "operational" tools for managing bank reserves in this disruptive period.

The total of reverse repurchase agreements has increased by $164 billion since the end of QE III.

Thus, $664.0 billion of the $756.0 billion reduction in reserve balances with Federal Reserve banks is related to the three Fed "liability" accounts mentioned above.

This has been how the Fed has managed bank reserves over the past two years.

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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.