Federal Reserve Watch: Downsizing Takes Time

Includes: TLT
by: John M. Mason

The Federal Reserve has reduced the size of its securities portfolio since the beginning of , and this reduces bank reserves.

However, bank reserves with Federal Reserve banks, a measure of "excess reserves" in the banking system have actually increased.

As the Fed does this, it is also reducing the use of "other tools" it has employed since the end of quantitative easing, but these add reserves to the banks.

The Federal Reserve System is in a position it has never been in before. It is in a period when it is trying to reduce the size of its securities portfolio and, consequently, reduce the size of its balance sheet.

This is why I am spending so much time looking at the Federal Reserve data. It is important for us to understand what the Fed is doing and whether or not it is accomplishing its goal of reducing the size of its securities portfolio.

The project, supposedly, got off the ground in October. According to the “forward guidance” given us by the Fed, Fed officials were planning to reduce the size of its securities portfolio by $10.0 billion in October - and another $10.0 billion in November. In each month, the planned reduction in the portfolio of US Government securities was to be $6.0 billion and the reduction in the mortgage-backed securities portfolio was to be $4.0 billion.

In October, using the information from the Federal Reserve Release H.4.1, “Factors Affecting Reserve Balances of Depository Institutions,” the Federal Reserve has reduced the size of its securities portfolio by $2.9 billion between the end of the banking week of September 27, 2017, and November 8, 2017.

During this time, the US Government securities portfolio declined by $5.4 billion and the mortgage-backed securities portfolio actually rose by $2.4 billion.

As I have mentioned in two previous posts (see this one and this one) that a lot of the timing of the reduction has to do with when the securities are maturing and what portion of the maturing part of the portfolio is replaced on the Fed’s balance sheet.

Just getting started on this project, it is obvious that we must be patient and give the Fed the benefit of any doubts, because, as I stated above, this exercise has never been done before.

The interesting change on the balance sheet is what has happened on the liability side of the balance sheet. Since the banking week ending September 27, the amount of reverse repurchase agreements on the Fed’s balance sheet has declined by $154.0 billion.

These reverse repurchase agreements represent the Federal Reserve “sales” of US Government securities to securities dealers under an agreement to repurchase them after a given number of days.

These are very short-term instruments. And, they have been one of the primary tools the Federal Reserve has used to manage its balance sheet since the end of the third round of quantitative easing in October 2014.

There are two accounts that are listed on the Fed’s balance sheet, reverse repurchase agreements with “Foreign Official and International Accounts” and “Others.”

It is the “Others” account that has been the primary “tool” of the Fed during the period of transition from quantitative easing.

Well, over the past five weeks, the amount of reverse repurchase agreements in the “Others” account has fallen by $145.6 billion. The amount in the “Foreign Official…” account has dropped by $8.4 billion.

What seems to be happening here is that the Federal Reserve is reducing its reliance on reverse repos as a part of the overall effort to shrink the amount of securities held outright on its balance sheet.

The total amount of “Others” reverse repos on the balance sheet has now fallen to $74.5 billion from the historic high this account reached of around $270.0 billion in December 2016.

Note that the amount of reverse repos in “Foreign Official and International Accounts” was around its historic high of $260.0 billion around the first of the year, and it has only dropped to about $230.0 billion in the latest banking week. This account is influenced by a lot of other things than the Fed’s current monetary policy, so one can assume that the decline since the first of the year has played a smaller role in the Federal Reserve balance sheet positioning.

There has been very little change in the US Treasury’s General Account at the Fed, the account it pays its bills from, since late September. The General Account is up only $5.2 billion over this time period.

The Fed, working with the Treasury Department, has also used this account to impact reserve balances at Federal Reserve banks, but seems to be playing a very small role right now.

Bottom line: the Federal Reserve has started to reduce the amount of securities held outright in its portfolio. However, Federal Reserve officials see this effort taking place right alongside the reduction in the use of “other tools” that have been the major source of balance sheet management since the end of quantitative easing.

The thing is that reducing the use of these “other tools” like the reverse repurchase agreement account actually increases “excess reserves” in the banking system.

Since September 27, 2017, the “excess reserves” in the banking system has risen by almost $140.0 billion.

Thus, the Federal Reserve has started to reduce the size of its securities portfolio, but while also reducing the size of its reverse repurchase agreements. The former action reduces the amount of liquidity in the banking system: the latter action increases the amount of liquidity.

So, the Fed is moving to shrink its securities portfolio, but not in a way that will cause pressure to rise on bank reserve positions.

As Federal Reserve officials have been very cautious all during the economic recovery from the Great Recession to err on the side of monetary ease, they seem to be carrying the same mentality into the effort to reduce the size of the Fed’s securities portfolio - and the size of the Fed’s balance sheet.

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.