Federal Reserve Watch: Might Fed Stop Reduction In Securities Portfolio?

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by: John M. Mason
Summary

Federal Reserve officials are talking about slowing down or stopping the reduction in the size of its securities portfolio.

It was always assumed that the Fed would stop the reduction before the securities portfolio fell back to the size it was before the Great Recession.

The timing of this discussion is earlier than imagined, but officials are dealing with slowdown of its effort to raise the Fed policy rate so this shouldn't be a surprise.

The word is that Federal Reserve officials are considering slowing down or stopping altogether the efforts to reduce the size of its securities portfolio, something it began in October 2017.

Nick Timiraos writes in the Wall Street Journal, “Federal Reserve officials are near deciding that they will maintain a larger portfolio of Treasury securities than they had expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down in sight.”

This comes after Federal Reserve officials signaled that they were slowing down the pace of policy rate increases in 2019.

It now appears as if the Fed is moving into a new phase of policy-making, one more reliant upon the pressures that are coming from the financial markets. That is, rather than telegraph the market what the Fed will be doing in terms of rate increases or reductions in securities holdings, the central bank will pay more attention to what the data are showing and moving policy variables incrementally as officials believe is necessary to achieve policy goals.

If had always been left open how far the reduction in the securities portfolio would go, but I believe that most analysts are surprised that the discussion has arisen so soon.

As of last Wednesday, the securities portfolio totaled $3,851.4 billion or $3.9 trillion.

On September 26, 2007, just before the Great Recession began, the Fed’s securities portfolio only totaled just under $780 billion or 0.8 trillion.

As far as the banking system is concerned, it is not so much the Fed’s securities portfolio, itself, that is so import, it is the amount of reserves that are available to commercial banks, free reserves that can be lent out to the private sector in bank lending.

These free reserves can be captured in the “cash” holdings in the banking system.

On September 26, 2007, the cash assets in the US banking system totaled $314.5 billion. This total includes vault cash, cash items in the process of collection, balances due from depository institutions and balances due from the Federal Reserve system.

Note that on this date, the balances due from the Federal Reserve System amounted to $27.5 billion. This item is on the Federal Reserve balance sheet.

On January 16, 2019, reserve balances with Federal Reserve banks totaled just over $1,625.0 billion.

These balances are often referred to as a proxy for the “excess reserves” in the banking system. They are the free reserves that commercial banks could go out an start lending to businesses.

It has been this total that economists, especially in the early years of the current economic recovery were so concerned about because of their inflationary possibilities on September 27, 2017.

It is these “excess reserves” that commercial banks could lend out, generating faster growth rates in the money stock, and thereby cause inflation to grow out of hand and create all sorts of problems for the recovering economy.

Well, the “excess reserves” did not get lent out and the runaway inflation did not take place. The runaway inflation did not occur. And, Federal Reserve officials were left with the problem of how to handle all these “excess reserves” in the banking system. And, this is were the effort to reduce the size of the Fed’s securities portfolio cam in.

One should also be aware of the fact that when one looks at the cash assets of the commercial banking system, one sees that if you subtract the total reserve balances with Federal Reserve banks from the total “cash assets” you can see that the rest of these “cash assets” remained relatively constant over the past ten years. Thus, commercial bank vault cash, cash items in the process of collection, and balances due from depository institutions remained within a band of roughly $60.0 billion.

And, banks were able to maintain this relatively constant amount given all the volatility In commercial bank activity over the past ten years and given the substantial reduction in the number of commercial banks that are in the banking system.

In other words, the commercial banking system functioned pretty much as it had done before the Great Recession, and the only real increase in commercial bank’s “cash assets” came in the excess reserves they held at the Federal Reserve.

And, for whatever reason, whether it be moral suasion, interest payments on reserve balances, or what, the “excess reserves” the Fed pumped into the banking system only went into the Federal Reserve line item, reserve balances with Federal Reserve banks.

This, therefore, is the amount the Federal Reserve is really worried about because this is the amount of “excess reserves” that are not used for the operational activities of commercial banks, but are the amount that would be available for these banks to lend out if lending activities picked up.

But, the commercial banks don't seem to be very anxious to begin lending these “excess reserves.” The six largest banks in the country all have achieved a return on shareholder’s equity in excess of ten percent. And, some of the banks have already scaled back their lending business for 2019 because of all the uncertainties that exist.

Furthermore, as I have discussed frequently, there seems to be little or no pressure on short-term interest rates as the Fed has been able to maintain very steady control of the effective Federal Funds rate. Right now, the financial markets are signaling that there is plenty of liquidity available in markets to satisfy all short-term needs for funds. There are no disruptions evident in the commercial banking system.

My own feeling is that, given the above analysis, the Fed could continue to reduce the size of its securities portfolio for the rest of this year or even longer. Especially with the banks slow lending pace, I don’t see any banking problems on the horizon.

Another issue is that the Fed would get back to the place where it’s portfolio is only made up of Treasury securities. The Fed’s mortgage-backed securities portfolio totals about $1.628 trillion right now, so further reduction in this part of the portfolio might take place over a very long time, but this reduction will really take place at its own pace/

Bottom line, I believe that Federal Reserve officials would still like to see the securities portfolio reduced by a substantial amount. They still, however, want to err on the side of too much ease where they avoid any possibility that they might cause another banking crisis or another recession. This especially, if the stock market starts to drop.

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.