Many Federal Reserve officials were out talking this week. The subject of much of the talk: The Fed's target rate of interest, the Federal Funds rate, needed to be raised at the March meeting of the Federal Open Market Committee meeting.
Odds were increasing during the week that such a move would take place in March and financial markets responded, especially with the value of the US dollar rising because of this belief.
Consequently, the Federal Reserve statistics from the banking week ending March 1, 2017 were disappointing. The balance sheet account, Reserve Balances with Federal Reserve banks, a proxy for the excess reserves in the banking system, rose by just about $65.0 billion.
The two previous times that the Fed raised its policy rate of interest, officials spent a month and one half to two months reducing excess reserves in the banking system to prepare the banks and the financial markets for the impending increase in the rate.
Last week, it seemed as if the Fed was starting to do this "reserve draining" once more as it prepared for the upcoming meeting of the FOMC on March 14 and 15. So, when the Fed officials started talking about raising the policy rate at the meeting, it seemed to coincide with the fact that the Federal Reserve was maneuvering its balance sheet to support such an increase.
So, the figures from the last week need to be explored a little more. The explanation seems to be that we are moving into tax season. Over the past week, the General Account of the US Treasury at the Federal Reserve dropped by about $80.0 billion. In the previous week, there was a $46.0 billion drop in the General Account.
Overall, since the end of 2016, the General Account of the Treasury has dropped by $225.0 billion.
Two things on this: First, the General Account has played a huge role in the managing of monetary policy since the end of the period of quantitative easing in October 2014.
Remember, the Federal Reserve has not used direct open-market operations, the buying and selling of US Treasury securities, since the end of QE3. The Fed has primarily used three tools to manage its monetary policy since then… reverse repurchase agreements, term deposits, and working with the US Treasury Department, the Treasury's General Account.
In December 2016, at the time when the Federal Reserve was trying to reduce "excess reserves" in the banking system to support the December increase in the Federal Funds rate, the General Account reached an historic high of nearly $400.0 billion. This account has never been close to this amount before. This shows the extremes that the Federal Reserve, along with the Treasury Department, has gone to conduct its operations without the use of open market operations.
On March 1, 2017, the General Account totaled just under $150.0 billion.
Second, we are now moving into tax season. Historically, the General Account moves downward during this period of time. In both 2015 and 2016, when markets were waiting to see whether or not the Fed was going to raise its policy rate every quarter according to the "forward guidance" that had been provided to traders, the General Account declined, which, as we have seen results in an increase in "excess reserves."
This, of course, makes it difficult for people to interpret exactly what is going on at the Fed.
The Treasury and the Federal Reserve act this way because the Treasury writes its checks out of the General Account, but receives tax money into Tax and Loan accounts that are with commercial banks. So, when a tax payer writes a check to the Treasury, the funds go into a Tax and Loan account at a commercial bank, and bank reserves do not change because the funds are transferred from one bank account to another.
When the Treasury gets ready to spend those funds, it transfers the funds from the Tax and Loan account into the General Account at the Fed. Thus, bank reserves would decline as the Treasury's General Account increased. In normal times, this transfer would usually be timed to match when the Treasury was writing checks to pay its bills, so the funds would be returned to the private sector at about the same time as the transfer was made from commercial banks to the General Account. By doing it this way, the least amount of disruption occurred to reserves in the commercial banking system.
Since the end of QE3, as mentioned above, this process was ended and the movement of funds into and out of the General Account was used to manage the amount of reserves in the banking system, hence the movement of the account to the historic highs reached in December.
Thus, we are moving into tax season and we have to deal with all these operational factors that can hide what the Federal Reserve is really trying to do.
The general pattern we have to deal with is that early in this period, the General Account declines, putting reserves into the banking system, which is the period we are in right now.
Then, as taxes are paid, the funds can start flowing back into the General Account and this will drain reserves from the banking system, and excess reserves will decline.
We just have to deal with these seasonal factors in trying to interpret what the Federal Reserve is attempting to do. One could also add that one reason that the runoff is so large is that the ability to manage the amount of reserves in the banking system during this post-QE3 period really gets stretched when the balances in the General Account are at historic highs like they were in December 2016.
To me, the Fed is being stretched so far with the limited tools it has to operate that we need to get back to the use of the Fed's security portfolio and some form of open-market operations sooner rather than later.
But, back to the current situation. This explanation of the movement of "excess reserves" may contribute to an understanding of why so many Federal Reserve officials are speaking out about the need for a rate increase at the March meeting.
Given that "excess reserves" in the banking system are increasing right now, when they had been decreasing during the time just previous to the two earlier rate increases in December 2015 and December 2016, Federal Reserve officials may feel that they have to get out into the public and give voice to their intention to raise the policy rate in March.
That is, the "signal" used in previous rate changes cannot be used this time around, so to prepare the banks and the financial markets for a March increase, the Fed officials have decided to get out and talk up the fact that they are really, actually preparing for a March move.
Note that they could still back off of such a move if the data coming in this next couple of weeks dictates not moving; remember, the Fed officials are "data-driven." However, most of the data coming in these days seem to support such an increase, and this is where I am betting. The Fed will raise their Federal Funds target range by 25 basis points at its March meeting.
We just need to keep our eyes on the data and try and understand what is going on.
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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.