Federal Reserve Watch: Preparing For The Battles Of 2017

|
Includes: EPS, IVV, LLSP, RSP, RWL, RYARX, SDS, SFLA, SH, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SSO, TALL, UPRO, VFINX, VOO
by: John M. Mason

Summary

Things have been relatively calm at the Federal Reserve since officials raised the policy rate of interest in December, stating their belief that there would be three increases in 2017.

Federal Reserve officials continue to talk up the "full employment" state of the economy and warn the incoming Trump administration not to get too carried away with stimulative economic policies.

Given the position being taken by these Fed officials, 2017 may evolve as a year of policy making turmoil with the Fed and the administration being on different sides.

Things have been relatively calm since the Federal Reserve decided to raise its policy rate of interest at the December meeting of the Federal Open Market Committee.

The effective Federal Funds rate, which had been at a 41 basis point level over the weeks leading up to the December meeting, moved up to 66 basis points once the target range was moved from 25 basis points to 50 basis points up to 50 basis points to 75 basis points.

The Fed conducted some "operating transactions" during the time between the December 13-14 meeting and the latest Federal Reserve report on January 11, 2017, but, by-and-large, every thing was pretty quiet on the Fed's balance sheet.

Furthermore, Federal Reserve officials continue to caution the incoming Trump administration about adding too much more stimulus to the economy because "The new administration is taking over 'at a time of arguably full employment.'" This from the from Chicago Federal Reserve President Charles Evans.

But, Evans was not the only Federal Reserve official speaking up this week. In addition to Evans, the Presidents of the Atlanta Fed, the St. Louis Fed, and the Dallas Fed also gave similar warnings about the state of the economy and the lack of a real need for injections of short-run stimulus to the economy.

Furthermore, these officials also pointed to the fact that the Fed had given markets after the December meeting some "forward guidance" that three more moves in the policy rate of interest were expected this year.

This comments seem to be a part of a consistent signal from the Fed to the incoming Trump administration that maybe a lot of new stimulus efforts are not needed at this time.

Last Friday, five Federal Reserve officials spoke to audiences around the country and gave off exactly the same message. Besides the presidents of the Dallas Fed and the Chicago Fed, last Friday's speakers included the presidents from the Federal Reserve District banks of Cleveland, Richmond, and San Francisco.

It seems as if there is a concerted effort to get the message across to Trump policy makers that maybe…just maybe…some prudence needs to be exhibited when it comes to producing more fiscal stimulus at this time.

Reserve Balances with Federal Reserve Banks, a proxy for excess reserves in the banking system, dropped by $266 billion in 2016 and have fallen by $612 billion since the Fed ended its third round of quantitative easing in October 2014.

Since, the officials met in December 2016, the Fed has seen Reserve Balances decline by just about $13 billion. The general reason for the decline was a runoff in the Fed's securities portfolio, although the drop was not in US Treasury securities…that is a no-no…but through a fall in the Fed's portfolio of mortgage-backed securities and a decline in US Federal Agency securities.

On the liability side of the balance sheet, there was a $5.5 billion rise in currency in circulation, which reduces the amount of the reserves in the banking system, and a decline in reverse repurchase agreements of $14 billion. Reverse repurchase agreements have been the primary tool used by the Fed to "fine-tune" bank excess reserves since the time that QEIII was ended.

Netting out the decline in factors supplying reserve funds to the banking system…the drop in the securities portfolio…and the decline in factors absorbing reserve funds from the banking system…the drop in Federal Reserve liabilities…excess reserves fell by just under $13 billion.

So, now we turn to the future…to 2017.

Fed officials have indicated that they expect to raise the policy rate of interest three time in 2017, each raise being 25 basis points.

In both 2015 and 2016, Federal Reserve officials indicated that four policy rate increases were expected in each calendar year. But, in each year, only one increase took place and that occurred at the December meeting of that year.

The reasons for the delay in policy rate movement…the economy.

The economy is still growing, but is only expected to grow in the future at roughly the same rate achieved since the end of the Great Recession. For the next several years, the Fed officials are only expecting the economy to grow by a little more than 2.0 percent per year, which is very close to the compound rate of growth of 2.1 percent achieved over the past seven and one-half years.

Unemployment is expected to stay below 5.0 percent, and for 2017, 2018, and 2019, the rate is seen to be at 4.5 percent. Full employment!

Inflation is expected to pick up, rising to the Fed's long-term policy objective of 2.0 percent.

With such an outlook, one can understand why Federal Reserve officials are leery about an incoming Trump administration that wants to pump up the economy with more and more tax cuts and infrastructure spending. This may be a point of contention between Fed officials and administration officials for some time.

From the operational side, however, we have seen how the Fed has operated over the past two years. When the Fed was preparing to raise the policy rate of interest it oversaw a reduction in the reserve balances with Federal Reserve banks…excess reserves.

When it was not sure of the timing of such an increase, excess reserves were allowed to remain constant or rise slightly.

I believe that Federal Reserve officials really intend to produce three interest rate increases this year. I believe that they are really serious about this because they don't want the Trump administration to produce stimulus policies that will raise the fiscal deficit. Thus, they are being very, very vocal in warning the incoming administration about the stage of the economic recovery and the fact that they are going to move.

Thus, I believe that the Fed will keep reserve balances…excess reserves… under tight control this year and will not allow them to increase at different times of the year as they have done in the past two years.

Fed officials need to keep a tight reign on excess reserves so that they can back up their talk and be prepared to move rates at any time during the year.

The Fed has an administration in the White House that they may have significant disagreements with…something that didn't exist over the past eight years. This means that Fed officials must be constantly "on guard" and prepared to move.

Of course, there are open positions on the Board of Governors which Donald Trump will have the pleasure of filling. Could be an interesting time.

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.

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500. Become a contributor »
Problem with this article? Please tell us. Disagree with this article? .