Federal Reserve Watch: Fed Keeps Reserves Into Commercial Banks

Aug. 10, 2021 9:00 AM ETTBT, TLT, TMV, IEF, SHY, TBF, EDV, TMF, PST, TTT, ZROZ, VGLT, TLH, IEI, BIL, TYO, UBT, UST, PLW, VGSH, SHV, VGIT, GOVT, SCHO, TBX, SCHR, GSY, TYD, DTYL, EGF, VUSTX, DTUS, DTUL, DFVL, TAPR, DFVS, FIBR, GBIL, UDN, USDU, UUP, RINF15 Comments12 Likes
John M. Mason profile picture
John M. Mason
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Summary

  • The commercial banking system now maintains the largest amount of reserve balances it has ever held, thanks to the effort of the Federal Reserve System.
  • Because of this liquidity in the banks, short-term interest rates are threatening to fall into negative territory and have not because the Fed sold $1.2 trillion in reverse repurchase agreements.
  • This is the dilemma the Fed now faces: it cannot go on buying securities at the current rate and keep short-term interest rates positive.
  • Other central banks in the world are moving to increase short-term interest rates and that will cause the value of the dollar to decline unless the Fed keeps short-term rates up.

US Federal Reserve building in Washington DC with blue sky
uschools/E+ via Getty Images

Reserve balances with Federal Reserve Banks reached a new historic high this past banking week. For the week ending August 4, 2021, reserve balances of commercial banks closed at $1,045.9 billion.

As can be seen from the following chart, reserve balances with Federal Reserve Banks, basically cash, (found on the Fed's weekly H.4.1 weekly release) took off in February as the Fed's accommodative monetary policy began to flood the banking system with liquidity.

Reserve Balances With Federal Reserve

In late March, however, the Fed became concerned that short-term interest rates in the U.S. were heading below zero.

The Fed did not want U.S. short-term rates to drop below zero.

You can see that the effective federal funds rate began to decline in the January/February period.

Effective February Funds Rate

To try and keep the short-term rate from falling below zero, the Fed began to engage in reverse repurchase agreements. That is, they sold securities under an agreement to repurchase them after a very short time.

This effort to sell securities increased as the spring went along and the Fed's accommodative policy of buying $120.0 billion in securities, outright every month.

By the middle of June, however, the use of the reverse repo window became sufficient enough that the effective federal funds rate ceased to fall and even rose to ten basis points, or, 0.10 percent.

The Value of the Dollar

The other player in this drama was the value of the U.S. dollar.

As the Federal Reserve gained control over the decline in the short-term interest rate and began turning it around, the value of the U.S. dollar started to rise.

Take a look:

Trade-Weighted US dollar index

By the middle of April the value of the dollar started to rise and this continued up through July. Currently, the dollar is running into some competition as the Bank of England and the European Central Bank have indicated that they are beginning to modify their monetary policies, making things a little tighter in their areas of operation, and this implies some rise in their short-term interest rates.

That is, the dollar, this fall, is going to face rising interest rates in other areas of the world, and this will make it harder for the value of the dollar to rise against other currencies.

This is something that needs close watching, but if the Federal Reserve is moving into the area of more overt tapering of its accommodative policy, then the value of the U.S. dollar should rise. I believe that this will be a test that investors can use in their efforts to try and understand just how effective the Fed's actions are in its efforts to gain control of the policy effort.

Federal Reserve Actions

The commercial banking system received $44.8 billion in excess reserves this past week. The Fed's purchases of securities from the open market totaled only $14.3 billion coming primarily from the addition of $13.9 billion in U.S. Treasury securities to the Federal Reserve portfolio.

Another $31.1 billion was added to commercial bank's excess reserves through the U.S. Treasury Department reducing its General Account at the Fed. As the Treasury writes checks on its General Account, these monies move from the Federal Reserve System to deposits in the private commercial banking system.

Just a note on the movement in the effective federal funds rate this past week. On Friday, July 30, the federal funds rate dropped to 0.07 percent.

This, to me, is an indication of how easy it is for the federal funds rate to drop. To me, the weakness in the short-term rate is due to all the liquidity that the Fed is pumping into the banking system and all the money the Fed has pumped into the banking system.

The tendency for the market is for the rate to decline. But, by Monday, the federal funds rate bounced back up to 0.10 percent. This seems to be what the Fed is shooting for right now because the rate remained at 0.10 percent for the following week.

This, to me, is evidence of what Federal Reserve officials is fighting right now.

What The Fed Is Trying To Do

The Federal Reserve has pumped an enormous amount of funds into the commercial banking system.

The banking system has more than $4.0 trillion in "excess reserves" at the present time. This is an enormous amount of "loose" money hanging around with little or nothing to do in the economy.

As a consequence of all, this loose money in the banking system, short-term interest rates want to fall.

However, the Federal Reserve doesn't really want short-term interest rates to fall, especially since short-term interest rates in the U.S. are close to zero.

Federal Reserve officials do not want negative short-term interest rates. Hence the reason for the use of reverse repurchase agreements, a short-term tool, to remove reserves from the commercial banking system and keep short-term interest rates in positive territory.

But, the Fed has over 1.2 trillion in reverse repurchase agreements on its books on August 4, 2021. This is ten months' worth of buying securities at a rate of $120.0 billion per month. That is, the Fed, this year has bought an amount of securities with its right hand sold relatively the same amount of securities with its left hand.

The Fed, in effect, is admitting that its "accommodative" program is presently putting way too much money into the banking system to keep short-term interest rates in positive territory.

The foreign exchange markets have responded to this by seeing that the value of the U.S. dollar declined.

Only since the Fed began to offset its monthly securities purchases by selling off securities at the same time in the repo market has the value of the U.S. dollar begun to rise.

If other central banks are beginning to modestly tighten up and produce a rise in their shot-term rates, this will just put more pressure on the Fed in terms of its short-term rates and the U.S. dollar.

This, to me, is the dilemma that the Fed is facing and it will not be an easy one to get through. But, I believe, that more and more pressure will be put on the Fed to act in a way that short-term interest rates in the U.S. will begin to rise. This may be a very tough fall.

This article was written by

John M. Mason profile picture
15.59K Followers
John M. Mason writes on current monetary and financial events. He is the founder and CEO of New Finance, LLC. Dr. Mason has been President and CEO of two publicly traded financial institutions and the executive vice president and CFO of a third. He has also served as a special assistant to the secretary of the Department of Housing and Urban Development in Washington, D. C. and as a senior economist within the Federal Reserve System. He formerly was on the faculty of the Finance Department, Wharton School, the University of Pennsylvania and was a professor at Penn State University and taught in both the Management Division and the Engineering Division. Dr. Mason has served on the boards of venture capital funds and other private equity funds. He has worked with young entrepreneurs, especially within the urban environment, starting or running companies primarily connected with Information Technology.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

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