Federal Reserve Exit Watch: Part 6

Debate seems to be picking up about the Federal Reserve exiting its current policy stance. Last week Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, and Charles Plosser, President of the Federal Reserve Bank of Philadelphia, spoke last week of the forthcoming need to wind down the Fed’s position. Hoenig said that the Fed should end its purchase program of mortgage-backed securities and Plosser talked about the recovery being sustainable even as existing fiscal and monetary stimulus programs recede.

Still, economists are pessimistic about when the Fed will begin to raise its target for the Federal Funds rate. The effective Federal Funds rate in recent months has averaged about 12 basis points. Bloomberg News conducted a survey of economists’ expectations and the median forecast was for the target rate to remain unchanged through September 2010 and then rise by a half of a point in December 2010.

Since the Federal Reserve finally realized in 2008 that there was a financial crisis and began to combat the unfolding chaos, the basic policy of the Fed has been to throw whatever it can at the wall so that a sufficient amount of what is thrown will stick so that a financial collapse can be avoided.

Can people who devised such a policy really be expected to move its target rate up until it is far past the time that a rise is needed? And, the Fed will then face a situation in which rising interest rates will put many holders of Treasury securities and mortgage-backed bonds underwater and the question will then be, “Can the Fed afford to raise interest rates too swiftly because of all the losses it will create?”

Right now, the Fed is subsidizing the profits of the large banks (and not the small- and medium-sized banks) by its interest rate policy (of course, the Obama administration has threatened to tax away a good deal of the profits). It is just amazing the contradictions in monetary and fiscal policy that are coming out of Washington, D. C. these days. Confusion reigns!

It is no wonder that businesses and banks don’t want to do much of anything these days. They don’t know what the economic policy and regulatory environment will be in three years, let alone three months.

Anyway, the Federal Reserve continues to add reserve balances to the banking system. In the past 13-week period ending Wednesday, January 13, 2010, the Fed has added about $84 billion in reserves to the banking system.

Remember in August 2008 when the total reserves of the whole banking system were only about $44 billion!

Of this $84 billion, $62 billion was put into the banking system in the latest 4-week period.

The major contributor to this increase was security purchases by the Federal Reserve in the open market. In the latest 4-week period, the Fed added almost $71 billion to its securities portfolio bringing the total new purchases for the last 13 weeks up to $233 billion.

A large portion of this increase went to offset the decline in several of the special facilities set up to handle the financial crisis. For example, the amount of funds supplied the banking system through the Term Auction Credit facility fell by about $80 billion over the 13-week period, by $10 billion over the last 4 weeks.

The swap facility with foreign central banks also continued to decline dramatically, falling by almost $38 billion in the latest 13-week period and by about $9 billion in the last four weeks.

In total, it appears as if the funds supplied the banking system through special financial crisis facilities fell by $42 billion over the past 13 weeks and by only $2 billion over the last two.

Thus, the Federal Reserve continues to let these special facilities wind down, replacing them in the banking system through open market purchases.

In terms of preparing for the Fed’s exit, there has recently been trading in reverse repurchase agreements with dealers, but there was no “practice” activity in the past four weeks presumably because of the seasonal Thanksgiving/Christmas churning in the banking system.

As of Wednesday, January 13, 2010, the Federal Reserve held $969 billion in mortgage-backed securities in its portfolio. The central bank has authorized purchases of up to $1.25 trillion going into March of this year. As mentioned earlier, there seems to be substantial debate within the Fed as to whether or not this program should reach the maximum total. We shall see.

The Fed now holds $777 billion in Treasury securities and $161 in the securities of Federal Agencies.

So, the Fed Exit watch continues. So far, the Federal Reserve has honored the path that it started out on: purchasing securities to add to its portfolio thereby replacing the funds draining away from the special facilities created to combat the financial crisis.

Obviously, the real test has not begun. Within the next month or two, if the recovery continues, the Fed is going to come under more and more pressure to start raising its target rate of interest. Until then, big banks will continue to arbitrage the Treasury market and the carry trade will continue to prosper. This behavior is based on the assumption that the Fed is not going to let short term rates rise for a while.

When this assumption is broken, expectations will have to be reset and there will be a re-adjustment in the financial markets as investors exit their arbitrage positions.

What the Fed does then remains to be seen.

However, by maintaining its current policy stance, if the economy doesn’t recover or goes into a double dip recession, the Federal Reserve cannot be accused of aborting the upswing by raising its target interest rate too soon.