Another Bump In President Trump's Plan For Fiscal Stimulus: The Fed Getting Back To Normal

by: John M. Mason


Federal Reserve officials are starting to discuss a return to more normal monetary operations, like open market operations: the outright buying and selling of Treasury securities on the open market.

These transactions have been suspended since the end of the third round of quantitative easing in October 2014, but need to be restarted for smooth Fed operations.

Beginning to conduct open market operations again and using them to support the Fed's attempt to raise interest rates will further conflict the Fed's monetary policy with Trump's fiscal policy.

Well, the subject is finally coming up. What subject, you say?

The subject of the Federal Reserve's balance sheet and whether or not Federal Reserve open market operations should begin again.

Open market operations, you say, what is that?

Well, back in the olden days, the Federal Reserve used to buy…and sell…United States government securities on a regular basis to manage the reserve positions of the commercial banking industry or to offset operating factors that inserted…or removed…bank reserves from commercial banks on a temporary basis.

In fact, the Federal Reserve used to use open market operations to conduct monetary policy.

During the current economic recovery, the Fed got out of the practice of using open market operations because of the permanence attached to such operations.

If you buy…or sell…a security, the transaction taken is expected to be "permanent."

The purchase or sale of the security might be reversed, but the initial meaning given to the transaction is that it will last.

Officials of the Fed were very concerned about the market's interpretation of these purchase or sales during the current economic recovery. The reason for this is that the Federal Reserve has acquired a substantial amount of government securities during the period of time it was "saving" the financial system and during the three rounds of quantitative easing that took place in the earlier years of the recovery period.

The concern of the officials was that Federal Reserve open market operations…especially the selling of US Treasury securities…which would reduce that amount of bank reserves in the banking system…might be taken the wrong way by the banking system causing commercial banks to "pull back" from any lending activities they might be doing in order to replenish the amount of reserves that they would like to hold.

The reason for this concern goes back to the 1930s, 1936 and 1937 to be exact, when the US economy was recovering from the Great Depression and bank reserves were considered, by Federal Reserve officials, to be relatively plentiful…perhaps even excessively so.

In order to reduce these "excess reserves" in the banking system, the Federal Reserve raised the reserve requirements that applied to the deposit accounts at commercial banks. This, of course, immediately reduced the "excess reserves" in the banking system.

Commercial banks stopped lending in order to get back to a more desired "excess reserve" position and this withdrawal of lending resulted in driving the US economy into another depression, the depression of 1937-38.

This time around, Federal Reserve officials wanted to be very careful whenever they attempted to reduce "excess reserves" so that they would not set off a situation like that observed in the mid-1930s and send the United States economy into another recession to follow the Great Recession.

As a consequence, Fed officials decided to use "financial tools" that were very short-run in nature or reversible, either automatically or by Fed actions.

The three "tools" that have been used since the end of the third round of quantitative easing are reverse repurchase agreements, term deposits, and US Treasury deposits at the Fed.

Reverse repurchase agreements occur when the Fed sells a Treasury security to a authorized trading desk under an agreement to repurchase that security at the end of three days, or five days, or whatever. Thus, the transaction is reversible, but the Fed must be constantly entering into further agreements in order to keep a certain amount of reserves out of the banking system.

Term deposits are an offering the Federal Reserve banks make to acquire deposits at a fixed rate for a given amount of time. The deposits can be for a week or two or more, so that the transactions do not have to be continually made in order to keep a certain amount of funds out of the banks.

US Treasury deposits in the Treasury's General Account at the Fed usually consist of tax collections that, under more normal conditions, would be held in Treasury Tax and Loan accounts at the commercial banks. Since October 2014, when quantitative easing was ended, the Treasury has worked with the Fed to bring more and more of these balances into the General Account, thereby removing reserves from the banking system.

The Federal Reserve has wanted to remove excess reserves from the banking system over time in order to make conditions in the banking system more amenable to the Fed raising it policy rate of interest. So, "excess reserves" have been removed from the banking system over the past two years.

On October 14, 2014, "excess reserves" in the banking system reached its all time high of $2,820.7 billion. On January 11, 2017, "excess reserves" amounted to $2,110.9 billion, a reduction of almost $710.0 million.

US Treasury securities held outright by the Fed was $2,455.3 million at the earlier date and $2,463.1 million on January 11. No manipulating bank reserves by open market operations here.

But, the other means of reducing "excess reserves" has come close to being as high as is comfortable. Whereas, reverse repurchase agreements have generally been in the $200 billion to $300 billion range, they have gotten as high as $470 billion, and through the end of the year 2016, they reached fairly high balances.

US Treasury deposits in the General Account were around $110 billion on October 14, 2014: and they were over $400 billion towards the end of last year.

Federal Reserve officials have overseen a smooth reduction in bank "excess reserves" over the past two years or so and have been able to avoid any major banking disruption from the removal of these reserves. But, it is hard to see how these "temporary" tools could be used to reduce bank reserves any further as Federal Reserve officials attempt to raise its policy rate further…even three times in 2017.

Consequently, Federal Reserve officials have started talking about starting up the use of open market operations again. One of the first out of the gate has been Governor Lael Brainard, who has started to lay out the prospect of getting back to open market operations and the problems that might arise with any aggressive use of fiscal policy by the incoming Trump administration.

It has also been noted that Patrick Harker, President of the Federal Reserve Bank of Philadelphia and Eric Rosengren, President of the Federal Reserve Bank of Boston, has also made public comments on the issue. It seems as if the Fed is starting the battle early against some of Trump's ideas.

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