Federal Reserve Watch: The Securities Portfolio Continues To Decline

by: John M. Mason

We have completed ten months in the Federal Reserve's effort to reduce the size of its securities portfolio.

During this ten months the Fed had signaled that it would reduce its securities portfolio by $220 billion and has actually come close to achieving a $206 billion reduction.

This action has been achieved with minimal disruption to the banking system, while, at the same time, the Fed has increased its policy rate of interest three times.

I have not written a Federal Reserve Watch since July 25. The following week, the Fed got rid of a very large “chunk” of its securities portfolio, just over $23 billion.

This brought the total reduction, including discounts and premiums counted on the balance sheet, to just under $55 billion during the period from the Fed’s balance sheet of June 27, 2018 to the balance sheet of August 1. 2018.

July was a very important month because the Fed’s schedule for balance sheet reductions jumped up to $40 billion per month… or, $120 billion per quarter for the third quarter.

In the second quarter of 2018, the Fed was only scheduled to reduce its balance sheet by $30 billion per month… or, $90 billion per quarter.

Since the end of September, 2017, when the reduction of the securities portfolio began, the Federal Reserve has reduced its portfolio by almost $206 billion.

This, I think, is rather impressive since Federal Reserve officials had signaled that they would reduce the portfolio by $220 billion during this time.

To be only $14 billion short of that target after ten months, I believe, is quite an accomplishment.

This reduction in the securities portfolio occurred while, at the same time, the Federal Reserve also increased its policy rate of interest three times, bringing the upper limit of its target range from 1.25 percent to 2.00 percent.

The effective Federal Funds rate has risen from around 1.15 percent in September 2017, to its current level of about 1.91 percent.

Everything, so far has gone smoothly, with no real bumps along the way.

In terms of the liquidity of the commercial banking system, we can look at the line item on the Fed’s balance sheet labeled "Reserve Balances with Federal Reserve Banks". I have used this measure as a proxy for “excess reserves” in the banking system. The only difference between the Reserve Balances measure and actual excess reserves in the banking system is that actual excess reserves include the coin and currency that banks hold on their balance sheet in addition to the reserve balances they hold at with Federal Reserve banks.

The coin and currency that commercial banks hold in their vaults is actually a relatively small number and doesn’t vary much except around holiday or vacation times when these balances are increased to meet the needs of the season.

Reserve balances with Federal Reserve banks were at $2,179 billion on September 27, 2017, when the securities portfolio reduction began. On August 8, these reserve balances were $1,966 billion… the reduction over this ten month period being just under $213 billion.

In a very real sense, these balances were “excess reserves” and their reduction seemed to cause no problem for the banking system.

So, the Federal Reserve reduced its securities portfolio by $206 billion and commercial bank’s excess reserves fell by $213 billion. Nicely done.

But, this accomplishment was even more astounding than that.

The public continues to need coin and currency to buy goods and services in the economy and so the drain of coin and currency out of the commercial banking system is something that the Fed must accommodate. So, over the past ten months, over $91 billion of coin and currency has left the commercial banking system, reducing excess reserves.

Offsetting this was a reduction in the Fed’s use of repurchase agreements, a tool that was the backbone of the Fed’s conduct of monetary policy between the end of the third round of quantitative easing and the start of the securities portfolio reduction when the Fed did not engage in overt open market operations.

Over the last ten months, the account where the intentional monetary activity took place declined by $218 billion. This meant that in reducing the use of reverse repurchase agreements, $218 billion in reserves were put back into the accounts of commercial banks. That is, this reduction increased excess reserves.

Now, just looking at these two accounts, the Fed has put a net $127 billion into excess reserves.

These had to be offset in some fashion in order to have the reduction in reserve balances - excess reserves - match closely with the reduction in the securities portfolio.

The solution: US Treasury deposits held in the General Account at the Federal Reserve. How much coordination was conducted between the Fed and the Treasury Department is unknown.

However, the amount of deposits held by the Federal Reserve declined by almost $146 billion from the end of September 2017 and August 8, 2018. This decline injected enough excess reserves into the banking system to offset the $127 billion shortfall cited above, with just $19 billion to spare.

That is, the factors absorbing bank reserves, net, increased by a modest amount over this past 10 years, smoothing out the transition from the use of repurchase agreements to manage the Fed’s balance sheet to the actual reduction in the Fed’s securities portfolio.

A masterful job!

So, where do we go from here?

Well, the Fed is scheduled to reduce its securities portfolio by $230 billion from the beginning of August to the end of December. Furthermore, the Fed has signaled that it will raise its policy rate two more times this year.

The economy seems to be doing well, but the federal government is creating more and more debt due to its spending and tax reduction programs. And, a trade war is just getting started that will disrupt markets and punish economies.

We may look back at the past ten months and say that the officials at the Fed actually had it easy at the start of its securities reduction program. Moving forward, we may be in for a much more volatile time.

This is why, I believe, it is so important to keep an eye on what the Fed is trying to do and how well it is accomplishing was it has set out to do. At least it gives us a yardstick to measure what is going on.

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.