Federal Reserve Watch: June Rate Increase?

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by: John M. Mason

Summary

Looking for the next Fed rate increase? Could it come next month? Stay tuned!

Federal Reserve officials are really in a transition period, and they need to look on to the future and stop dwelling so much on the past on troubled banking system.

And the Fed needs to move back to buying and selling securities outright so that it can be prepared for all the other issues it might have to deal with.

The market focus now seems to be on rate increase at the meeting on June 13 and 14 of the Federal Reserve's Federal Open Market Committee.

After the Fed's increase in March, the market seems to be betting that Fed officials will come through on their current "forward guidance" and produce two more rate increases this year. The other factor markets are looking for is any indication that the Fed will start reducing the amount of open market securities it has on its balance sheet. The odds favor that the Fed will begin to start reducing its balance sheet this year - the only question seems to be when?

A "fun fact" came out in this week's Federal Reserve data as presented in the H.4.1 Federal Reserve release. Since the third round of Quantitative Easing ended in October 2014, the Total Factors Supplying Reserve Funds, in essence, the total assets of the Federal Reserve System, there has been no change - let me repeat - zero increase in Total Factors Supplying Reserve Funds to the banking system.

On May 3, 2017, Total Factors Supplying Reserve Funds was $4,517.6 billion, and on October 15, 2014, the date that QE3 seemed to end, Total Factors Supplying Reserve Funds was $4,517.6.

How ironic is that?

If you look on the balance sheet and net out the securities held outright by the Federal Reserve System and the amortized premiums on securities held outright, you see that the change between the two dates is roughly zero.

So, what has happened to the "excess reserves" in the banking system over this time period?

Well, "excess reserves" in the banking system, using the proxy number from the Fed's balance sheet line item Reserve Balances with Federal Reserve Banks has fallen by $620 billion. Note that on May 3, 2017, there were still $2,317 billion in excess reserves in the commercial banking system.

With no increase in the Factors Supply Reserve Funds, Fed officials used four tools to reduce the "excess reserves" in the banking system. The supply of currency in the hands of the public has risen by $250 billion since October 15, 2014; the amount of funds in the Treasury's account at the Fed has risen by almost $176 billion, and the amount of reverse repurchase agreements outstanding has increased by almost $212 billion. The Fed used the Term Deposit facility during this time period to manage reserve positions, but there was no change here between the two dates. Note that other insignificant factors declined by around $18 billion.

Before two of the three Fed rate increases since the end of QE3, the Federal Reserve removed reserves from the banking system in preparation for the move in the policy rate. The only time this did not happen was before the March 2017 increase.

The Fed lets currency in circulation increase as the demand for currency draws cash from the banking system. The Fed does not really do anything to control the amount of currency in the economy. So the increase in currency in circulation between the end of December and the March FOMC meeting was market driven. Also, term deposits were not used during this period.

Federal Reserve officials allowed the two other "tools" to run off after the end of December 2016 from historically high levels. I believe that these officials did this to allow them some operating room if they needed it. Treasury deposits at the Fed declined by $333 billion in a typical seasonal move before tax season and reverse repos declined by $97 billion. These movements, along with some operational factors, resulted in "excess reserves" rising by $425 billion during this time.

This swing in reserves seemed to present no problem to the Fed's action to raise its policy rate in March. Since March 15, "excess reserves" in the banking system have fallen by $167 billion. The decline came through the movement of funds, generally tax monies, going into the Treasury account at the Fed.

This reduction in bank reserves begins to set the stage for the possibility of the next rate increase coming in June.

The thing is that tax season is over and the funds flowing into the Treasury's deposit account at the Fed during tax season may be flowing out as the Treasury writes checks on its Fed account as it spends money. For example, although Treasury deposits have increased since March 15 by almost $200 billion, these deposits have fallen by $72 billion just in the last banking week.

The decline in Treasury deposits was offset by a similar increase in reverse repos so that reserve balances did not change at all. But the question remains about how long Federal Reserve officials can go along on the current operating plan using just short-term, temporary tools to manage bank reserve positions?

To me, it looks like it is time, if not past time, to begin to start reducing the amount of securities the Fed holds on its balance sheet. I know that Fed officials have wanted to be very careful in reducing its balance sheet back to "more normal" levels, they did not want to cause disruptions to a fragile banking system.

But it has now been almost eight years since the current economic recovery began. And it has been two and one-half years since the third round of quantitative easing has ended. It is time for commercial banks to stop relying on the central bank to underwrite their solvency. Bank capital ratios are up significantly. Bank profits seem to be at adequate levels. Bank liquidations are at a minimum. And bank lending seems to be increasing at reasonable pace.

Let's move the Federal Reserve back into a more normal operating mode.

I believe that Federal Reserve officials should begin to allow securities in their portfolio to mature without being replaced, and they should begin to do this as early as June or July. Of course, the Fed should manage the reduction in the securities portfolio, but it should get started.

The Fed should also raise its policy rate again, laying the groundwork for another increase in November or December. It's time for the Fed officials to start looking forward rather than just looking over their shoulders at the past.

There is enough going on in the world to require their full attention to what might happen: a massive Trump tax reduction along with deregulation of financial institutions; the health of the European Union and the euro; the continuing advancement of China and the yuan; the affairs in Russia and the Middle East; and other hot spots in the world. The past is gone.

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.

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