Federal Reserve Review: Fed Kept Funds Rate Constant Last One-Third Of Year

Summary

• The Federal Reserve has kept its policy rate of interest constant for the last four months, selling securities under an agreement to repurchase, and continuing to buy lots of securities, outright.
• The Fed is now tapering its purchases, stating that it will raise its policy rate of interest once the tapering ends: however, there is little to guide us in 2022.
• We have reached the current point where commercial banks have massive amounts of excess reserves and financial markets have issued massive amounts of debt.
• Government debt continues to rise and little is being done to control the expansion of credit in the U.S.
• At some time, maybe 2022, some of these dislocations and uncertainties are going to need attention, and there is really no indication that the leaders at the Federal Reserve know what to do.

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What policy guideline did the Federal Reserve follow for the last one-third of 2021?

The Federal Reserve kept the effective Federal Funds rate constant at 0.08 percent from September 1, 2021, to December 29, 2021.

Here is the chart.

Before September 1 the leaders of the Federal Reserve were faced with the possibility that the Fed's policy rate of interest might go into negative territory.

As can be seen in the following chart, the effective Federal Funds rate dropped to the 0.06 percent level in May and June. This drop occurred because the Fed was adding $120.0 billion to its securities portfolio every month.

The liquidity in the financial market was driving short-term interest rates toward negative territory.

Jerome Powell, Fed Chairman, and others leading monetary policy decisions did not want the Fed's policy rate of interest falling into negative territory.

So, the Fed's leaders reacted.

The effective Fed Funds rate bounced up to 0.10 for July and August.

By September 1, the Federal Open Market Committee came together and determined that the effective Federal Funds rate should move to 0.08 percent and remain there for an extended period of time.

As can be seen, the Federal Reserve has been very successful in maintaining the effective Federal Funds rate at that level for the remainder of the year.

Monthly Purchase of Securities at the Fed.

The Federal Reserve maintained its signaled monthly purchases of securities throughout all of 2021.

From December 30, 2020, to December 29, 2021, the Federal Reserve added $1,539.4 billion of securities purchased outright to its portfolio.

The monthly average works out to be $128.3 billion added each month in 2021.

So, the Fed was pretty close to the number it promised when it began its stated program to build up its securities portfolio. And, it was very regular, as can be seen by the chart.

The question then becomes, how did the Federal Reserve maintain the effective Federal Funds rate at 0.08 percent for the last four months of the year?

Given the volatility of the financial markets over this past year, one cannot expect that the Federal Funds rate remained constant for the last four months all on its own.

Well, it certainly didn't.

The Federal Funds rate was maintained because the Federal Reserve sold securities in the securities repurchase market to control the interest rate during this period of time.

Use Of Repurchase Agreements

In fact, the Federal Reserve sold massive amounts of securities in the 'repo' market over the year.

Note that in May, repurchase agreements start to move upwards. This was when the effective Federal Funds rate dropped into the 0.06 percent range.

It is in early July that 'repos' really begin to take off.

Remember that in July and August, the effective Federal Funds rate popped up to around 0.10 percent.

Beginning in September, it appears as if the Federal Reserve was a pretty regular participant in the 'repo' market, selling securities when needed to keep the effective Federal Funds rate at 0.08 percent.

The fact that the effective Federal Funds rate stayed so steady after September 1 supports the conclusion that the number one target for Federal Reserve operations following this date was to keep the Federal Funds rate constant.

The monthly purchase of securities. Well, Fed officials kept up that promise.

But, the Fed, on the other hand, sold securities to keep the Federal Funds rate from dropping into negative territory.

And the amount of 'repos' needed was not insignificant.

From September 1, 2021, to December 29, 2021, the Federal Reserve added $544.5 billion to the amount of securities it sold under an agreement to repurchase after a short period of time.

The amount of securities the Federal Reserve purchased outright during this same period of time: $464.0 billion.

That is, the Fed sold $80.5 billion more securities during this four-month period of time than it purchased!

As a consequence, reserve balances with Federal Reserve banks, a proxy for excess reserves in the banking system, dropped by $166.5 billion. That is, the Federal Reserve actually withdrew this many bank reserves from the banking system over this four-month period.

And, this removal of reserves was done so that the effective Federal Funds rate remained constant.

Reserve Balances With Federal Reserve Banks

For the full year, however, the Federal Reserve pumped almost $900.0 billion of reserve balances into the banking system.

Note that just before the Great Recession, $900.0 billion was almost the total amount of Federal Reserve assets!

This increase is massive!

And, yet, this amount also accounts for the reduction in reserve balances or $166.5 billion that occurred after September 1.

One can see that the pressure for interest rates to fall increased during the early part of the year, up through March and into April, and this is when we saw the effective Federal Funds rate fall.

By May and June, reserve balances began to level out as the Fed began to use repurchase activity to offset the $120.0 billion in monthly purchases.

In July, we see the big drop in reserve balances. This coincides with the big increase in the volume of repurchase agreements that also took place at this time.

Another plateau was reached beginning in September. This leveling is carried out through the fall months until we reach December when the reserve balances actually fell, bringing the total decline through the last four months of the year to $166.5 billion.

And, that is where we are right now.

Now, For 2022

So, what is the Fed now up to?

The Fed is tapering its monthly purchases in securities purchased outright.

The Fed is saying that once the tapering ends, it will oversee a rise in its policy rate of interest. This is now expected sometime in March.

But market rates of interest are rising.

For example, the yield on the 2-year U.S. Treasury note has risen from around 0.20 percent on September 1 to around 0.75 percent at the present time.

The expectation is for interest rates to go higher in the near term.

The Federal Reserve is going to have to 'let go' of the current range for its policy rate, but, given the movement in market rates of interest, will the Fed go in for two increases this year? For three increases?

And what is the Federal Reserve going to do with all of the repurchase agreements it has on its balance sheet?

I don't think the Fed is going to start selling securities, outright, from its securities portfolio.

I don't think that the Fed really wants to be in a position where it has to reduce its securities portfolio.

This is a dilemma that Mr. Powell and the Fed are going to have to work out.

And, this dilemma is combined with concern over rising inflation.

Furthermore, the banking system, as shown above, has more than $4.0 trillion in excess reserves. What is the banking system going to do with these excess reserves this year? How might the Fed respond to these moves?

Mr. Powell and the Federal Reserve leaders are going to be faced with a multitude of issues in the not too distant future.

No one really knows how the Fed is going to react to these issues. So, welcome to 2022. Happy New Year!

Analyst’s 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.