Monday, May 26, 2008

Federal Reserve Operations: March 12 through May 21

We are in a brave new world of Fed watching. There are line items on the balance sheet of the Federal Reserve that we have never seen before. The item “Nonborrowed Reserves at Depository Institutions” turned negative in January of this year and has remained negative ever since. How can you have negative nonborrowed reserves? There is a lot of ‘stuff’ going on…and we don’t quite know what to make of it.

The bigger concern is about the state of the economy. Given all these changes to the operating procedures of the Federal Reserve and the new items on the balance sheet…is the Fed doing what it needs to do…or more? Is the Fed monetizing the Federal debt, as participants in international financial markets have been betting on for six years or so…or is the Fed just doing what is needed to resolve the liquidity crisis and its attendant problems and no more?

This is my first go at this effort since the change. I waited for two months to see if some sense could be made of the Federal Reserve statistics so as to avoid some of the ‘noise’ of the initial changes. It, necessarily, will be a rough analysis.

Let’s start from the ‘top down’ so to speak. The year-over-year rate of growth of the broader measure of the money stock (M2) has accelerated in the past three months. After staying in the 5.0%-5.5% range for most of 2007, the rate jumped to 6.7% in February, 7.1% in March and returned to around 6.5% in April, where it has stayed. So, money stock growth has accelerated modestly, but the initial move upwards came before the major operating changes which took place in March.

The total reserves in depository institutions, which had been decreasing through 2007 by a little more than 1.0%, increased a bit in February but then jumped to a year-over-year rate of increase of 4.9% in March and 2.3% growth in April. Something was happening. The rate of increase in the Monetary Base, the sum of reserves and things that could become reserves, remained relatively constant during this time at around a 1.0% rate of growth.

The conclusion one can draw so far from looking at these aggregates is that there has been some acceleration but that the changes are not too disturbing at present. We need to examine the basic disaggregated data as presented on the sources and uses statement of the Federal Reserve and see if any patterns can be discerned. But, this is difficult These data are found on the Federal Reserve release H.4.1, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.” The problem now is that we have to deal with things like the Term Auction Facility (TAF), the international swap lines, and the Primary Dealer Credit Facility among other things. And, we need to deal with the fact that whereas these items are increasing, the traditional items used in conducting monetary policy are decreasing…things like Securities Held Outright.

Our first look is at the item Federal Reserve Bank Credit. This is the operating total that shows the changes that take place at the Federal Reserve that can represent monetary policy. Reserve Bank Credit averaged $869.2 billion in the banking week ending March 12, 2008 and averaged $871.2 billion in the banking week ending May 21, 2008. For the whole period Reserve Bank Credit averaged $869.6 billion. The high value for the period was reached in the week of March 19 at $878.8 billion, when all the new changes were introduced. What caused the changes between March 12 and May 21?

The most dramatic change that took place was the reduction in Securities Held Outright. The decline in this item totaled $206.3 billion which is huge. This decline represents almost 30% of the securities that were held by the Federal Reserve in the week ending March 12. What offset this decline?

First off, Repurchase Agreements, a familiar item, rose by $64.3 billion. (Reverse Repurchase Agreements remained roughly constant during this time period.) And, Loans to Depository Institutions rose by $27.7 billion. This latter item seems to be an old familiar item too, but…primary loans…traditional loans from the discount window rose by only $13.4 billion. The rest of the increase came in something new called Primary Dealer Credit Facility which rose $14.2 billion. This item represents loans to the primary security broker/dealers that the Federal Reserve deals with. This facility became available on March 16, 2008.

In terms of the other new facilities that have been added to the Fed’s arsenal, the Term Auction Facility averaged $125.0 billion in the banking week ending May 21 which represented a $65.0 billion increase over the average of the week ending March 12. The Term Auction Facility was begun in December 2007 and has been increased steadily since then. In terms of supporting Bank Reserve Credit, this has been the primary source of funding.

The TAF has not been the only major new source of bank reserve credit. The Federal Reserve set up swap facilities with the European Central Bank and the Swiss National Bank to provide dollars to financial institutions that needed them in Europe. This swap line does not have its own individual line item on the Fed’s statement but is included in the line item “Other Federal Reserve Assets”. Most of the changes in this account since the creation of this facility in December of 2007 have been due to the drawing down of this swap line. Since the week ending March 12 of this year the total has increased from a weekly average of $42.2 billion to a weekly average of $93.1 billion during the week ending May 21, a rise of about $50.7 billion. This facility has been raised in volume, but has also been extended until January of 2009 since its implementation in December 2007.

The net effect of these changes has been a $1.4 billion increase in Reserve Bank Credit…roughly a balance. The conclusion that one can draw from this is that all the new innovations that the Fed has introduced over the past two months or so have changed Reserve Bank Credit very little. In fact, the monetary base has risen by roughly the same amount over this period. So the rise in total reserves, which has been a modest amount has come mostly from this increase in Bank Reserve Credit and a modest movement from Currency outside of depository institutions back into the banks.

It looks as if the Federal Reserve has made all of these adjustments without causing a major inflation of reserves or monetary measures. If this is the case, then well and good. The intended result of the innovations, we were told, was to get liquidity to the right parties on a real time basis and in the large quantities that were needed. The speed and the size of the effort was of crucial importance. And, we were also told that these measures were temporary and will be removed once the problems have receded. Almost everything that has been put in place has an expiration date. The best we can do right now is continue to watch and continue to hope for the best. There is still much concern that there are still adjustments that have to be made, both in financial institutions and in the economy.

In the meantime there has been some second guessing going on about the Fed’s cut in interest rates. John Authers in his column “The Short View” in the Financial Times last Wednesday argues that “The market is beginning to think that the US Federal Reserve has got it wrong.” The argument is that the Fed should not have cut interest rates so drastically and just concentrated on providing liquidity to the markets. The concern is that, with the rise in oil prices and other commodities, the Fed has “unleashed another bubble.” Authers article can be found at In other words, the Fed over-reacted to the liquidity needs of the market and may have created more problems for itself in the future.

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