Federal Reserve Watch: Fed Keeps Things Steady

Summary

• The Federal Reserve continues to purchase open-market securities outright as it attempts to support the economic recovery and get inflation moving at a faster rate.
• Through its actions over the past year, there seems to be plenty of liquidity in the banking sector and in the corporate sector, keeping short-term interest rates low.
• The government is planning a new round of fiscal stimulus and the Fed has promised to be there to support the program, erring, if in any way, toward monetary ease.

The Federal Reserve continued to buy securities this past week, and the banking system, with JPMorgan Chase & Co. (JPM) and the other big banks providing some pretty good 2020 earnings, appears to be in a very good position.

Reserve balances with Federal Reserve banks, a proxy for excess reserves in the banking system, came in at $3.150 trillion, which is up from the end of last February, when the Fed started pumping reserves into the banking system, by $1,470 trillion.

The banking system has a lot of cash in its vaults. One can note that the U.S. corporate sector is sitting on the largest amount of cash ever. There is plenty of liquidity sitting on balance sheets in the American economy.

In the money market, the effective Federal Funds rate remains at 0.09 percent. The rate ended the year at 0.09 percent.

In the last week of February 2020, the effective Federal Funds rate averaged 1.58 percent. As the Fed flooded the banking system with liquidity, the rate fell to 0.09 percent and remained there the rest of the year.

What About The Term Structure Of Interest Rates?

As has been noted, the bond markets have been reflecting that investors are expecting the rate of inflation to go up in the near term.

At the end of 2020, the inflationary expectations built into the yield on the 10-year U.S. Treasury note was right around 2.00 percent. This past week, inflationary expectations averaged 2.13 percent, indicating that some of the expected rise has found its way into the bond markets.

As far as the term structure of interest rates, the difference between the yield on the 10-year U.S. Treasury note and the 2-year U.S. Treasury note was 0.97 percent. At the end of 2020, the spread was at 0.92 percent, so there has been a slight rise in the term structure of interest rates.

This is a positive indicator for the economy, in that market participants are expecting rising short-term interest rates in the future. This is a sign that the economy, and inflation, will be rising.

Note that at the end of February 2020, this spread was 1.30 percent, or 130 basis points. The drop that took place after this time period reflects the fear of a major decline in economic growth and in inflation. The decline was, of course, due to the spread of the coronavirus pandemic and the following economic recession.

So, investors seem to be thinking that the economy is going to improve in 2021 and beyond, and this will result in rising inflation and in rising interest rates. This is good news.

And with the prospect of the Biden administration pushing through a $1.9 trillion fiscal package in the near future, the hopes are rising.

Chairman Jerome Powell and others within the Fed have indicated that the Federal Reserve is in support of such a stimulus package and will support it in terms of monetary policy.

Fed Continues to Buy Securities

The Federal Reserve continues to buy securities in the open market on a regular basis. This last banking week, the Fed purchased outright just over $80 billion in securities. Since the end of December, December 30, 2020, the Federal Reserve has added $115 billion to its balance sheet.

Note that since the Fed began to pump money into the system last year, this was at the end of February, the Federal Reserve has acquired $3.0 trillion in new securities.

Thus in terms of the Fed supplying reserves to the banking system over this time period, the total number amounts to almost $3.260 trillion.

Also, note that at the end of the last banking week, the special programs aimed to support specific areas of the financial spectrum, like municipalities, the corporate credit facility, the commercial paper funding facility and others, contain balances that only amount to a little over $46 million. Since December 30, 2020, these accounts have returned almost $58 million to the Fed.

So, it seems as if all the efforts extended by the Fed over the past year have pretty well done their job.

Where These Funds Have Gone This Year

The major channels these funds have gone into are just two.

As in any period of recession or uncertainty, people want cash. Cash continues to flow out of the Fed at a very rapid rate. But the interesting thing this year is that cash did not flow back into the banking system like it usually does in normal times. That is people take cash out of the bank to pay for holiday expenses, and then, as soon as the Christmas season is over, the cash flows back into the banks.

This year, currency in circulation has risen by almost $11 billion since the end of the year.

Note that since the economy tanked last March and the spread of the virus got worse, people have removed almost $300 billion in cash from the banking system. This has ultimately been supplied through the Fed’s open market purchases.

The other major shift on the Fed’s balance sheet in terms of the usage of the Fed’s purchase of securities is the build-up of U.S. Treasury balances at the Fed in the Treasury’s General Account.

Since the end of February 2020, the Treasury’s General Account has increased by $1.250 trillion.

Thus, the Fed has bought outright $2,270 in U.S. government securities. Right now, 55 percent of the Fed’s purchases have gone right into the Treasury’s account at the Federal Reserve.

Going Forward Into 2021

The U.S. government is planning a $1.9 trillion fiscal package to be enacted as soon as possible. This fiscal program will have a significant impact on the amount of government debt that will have to be issued during the year. And the government’s debt continues to rise due to the deficits created by the drag of the economic recession and pandemic crisis.

The Fed has indicated that it will stand behind the government in the effort to get the economy moving faster and to put people back to work. It is unknown how this will impact the Fed’s purchases of government debt in 2021 or in 2022.

Right now, the financial system and corporations appear to have plenty of money on hand. However, the one thing the Fed doesn’t want to do is to make some kind of an error on the side of not being loose enough.

If anything, the Federal Reserve, if it is going to err, wants to err on the side of monetary ease.

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.