Federal Reserve Watch: Reduction In Securities Held Outright But An Increase In Excess Reserves

Summary

• Federal Reserve officials indicated that they were going to reduce the Fed's portfolio of securities beginning in October, and they did.
• An increase in commercial bank excess reserves, however, was not expected.
• Lesson learned: the reduction in the Fed's portfolio of securities is not going to be a straight-forward affair.

Well, the first month of the Federal Reserve’s effort to reduce the size of its balance sheet has been completed. The total amount of securities held outright by the Fed fell by $5.6 billion from September 27, 2017, to November 1, 2017. In the banking week of the month of October, the amount dropped by $5.8 billion, the full amount coming in a decline in US Treasury securities held outright.

In the time between September 27 and November 1, the total of mortgage-backed securities on the Fed’s balance sheet actually rose by $2.4 billion.

Federal Reserve officials are intent on sticking to the schedule of securities reductions announced earlier, which would have meant that in October the amount of securities held outright would drop by $10.0 billion. Of this decline, US Treasury securities would have declined by $6.0 billion and mortgage-backed securities would have declined by $4.0 billion.

As reported in my last Federal Reserve Watch, the actual timing of when the reductions take place will depend upon the schedule of the actual maturity of the securities and the Fed’s efforts to replace some of them. Thus, the figures may deviate from the schedule on a month-to-month basis. The interesting thing is that while Federal Reserve officials oversaw the reduction of the securities portfolio, the “excess reserves” in the banking system, officially titled on the balance sheet as Reserve Balances with Federal Reserve Banks, actually rose by $102.7 billion in the September 27 to November 1 time frame, and increased by $39.9 billion in just the last banking week as the Treasury security account fell.

So, the Fed reduced its portfolio of securities held outright, which reduces excess reserves in the banking system, but saw excess reserves actually increase of the time period.

What’s going on?

Well, the Federal Reserve reduced its total of securities held outright, but at the same time, it also reduced its volume of reverse repurchase agreements, a tool that reduces the amount of excess reserves in the banking system.

Reverse repurchase agreements on the Fed’s balance sheet actually represents a Fed sale of securities - under an agreement to repurchase them at a later time, usually on a matter of days. Thus, the Fed reduced its holdings of securities bought outright - but it reduced its sales of securities where it agreed to repurchase them sometime in the future. This past banking week, the Fed may have reduced the size of its securities holdings - by $5.8 billion, which took reserves out of the banking system - but at the same time, it reduced the amount of reverse repurchase agreements on its balance sheet by $27.9 billion.

In essence, the Fed reduced the size of its securities portfolio, while at the same time, it stopped selling so many of its securities subject to a repurchase agreement. This is why excess reserves rose in the banking system in the last banking week.

Note that since September 27, 2017, the decline in the Fed’s reverse repurchase agreement account actually fell by $135.1 billion, which contributed to the fact that excess reserves rose over the last five weeks by $102.7 billion, as reported above.

So, what is the lesson we have learned here?

The Federal Reserve is going to reduce the size of its securities portfolio, but this may not actually mean that the amount of excess reserves in the banking system will decline… or, decline by the same amount that the securities portfolio does.

I have noted before that at the end of 2016, the Fed’s use of these reverse repurchase agreements reached an all-time historical high. On December 28, 2016, reverse repurchase agreements on the Fed’s balance sheet reached $573.8 billion! That is reverse repurchase agreements amounted to almost 12.0 percent of the Fed’s total assets! This was obviously a reason why the Federal Reserve had to get back to more normal operations - regular open market operations. The use of special tools to manage the Fed’s balance sheet was straining the central bank too much.

But the Federal Reserve was also working side-by-side with the US Treasury Department using the Treasury’s General Account at the Fed as a “special tool” to help manage the Fed’s balance sheet.

On November 30, 2016, the Treasury’s General Account at Federal Reserve banks reached a total of $422.0 billion, a historic high! And, this was not just a seasonal swing in the amount. There is no end of November upward swing in the Treasury’s General Account in history, especially to these levels. The rise had to be connected with the Fed’s efforts to manage its balance sheet and not to any seasonal reason for the increase.

So, I think we have learned something.

The Federal Reserve is going to reduce the size of its securities portfolio over time. However, how this will be accomplished and how it will impact commercial bank excess reserves must be examined almost on a week-by-week basis because of all the other “special tools” Federal Reserve officials have used since October 2014 when the Fed ended the third round of its quantitative easing.

Like I have said before - this is going to be an interesting time.

Analyst’s 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.