Wednesday, February 24, 2010

The Fed and the Treasury Maneuver

Yesterday, the Treasury announced that it will borrow $200 billion from the Federal Reserve and leave the cash on deposit with the Fed. As it initially goes on the Fed’s balance sheet the transaction is a wash.

The Treasury has two accounts that show up on the Federal Reserve sources and uses statement. (These data can be found on the Federal Reserve release H. 4.1, Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.) The first is called the U. S. Treasury, General Account, and this is primarily used to manage the Treasury’s cash position and flow of expenditures and tax receipts.

When taxes are collected, the funds flow into government tax and loan accounts at commercial banks. This transfer of funds from the private sector to the public sector causes no disruption to bank reserves because the funds stay in the banking system. (The data on U. S. Government deposits at commercial banks can be obtained in the Federal Reserve release H.6, Money Stock measures, Table 7.)

The Treasury does not draw funds out of its accounts in the commercial banking system until it begins to make payments out of its balance in the General Account at the Federal Reserve so as to cause as little disruption to the reserves held in the banking system. That is, government funds come out of the banking system and go into the Fed account, but the Fed account is being drawn down with payments to the private sector that will be deposited into commercial bank deposits.

For example, government demand deposits at commercial banks averaged $1.3 billion in December 2009. However, in January, as tax collections flowed into the government, these balances rose to $1.6 billion in the banking week ending January 4 and increased to $2.3 billion, $4.3 billion, and $5.1 billion, in the next three weeks, respectively. In the banking week ending February 1 the balances fell to $1.8 billion and then dropped to $1.3 billion in the following week as the Treasury paid out funds to the private sector.

These movements just represent operational procedures that have been established over the years to avoid major movements of funds into and out of governmental accounts. Hence, this is called the “General Account.”

On September 17, 2008, the Treasury Department announced something called the “Supplementary Financing Program”. Under this program the Treasury was to issue marketable debt and deposit the proceeds in an account that would be separate from the General Account of the Treasury at the Fed.

Thus, the Fed’s holdings of U. S. Treasury holdings would go up on the “asset” side of the balance sheet (this being a debt of the Treasury) and the U. S. Treasury Supplementary Financing Account would rise on the “liability” side of the balance sheet (this being an asset of the Treasury).

In September 2008, this account averaged almost $80 billion. In November 2008 it was above $500 billion. The account dropped to just below $200 billion in January 2009 and remained around that level into September 2009. The figure drops precipitously from there as the issue about the debt limit of the Federal Government had to be dealt with. In January and February 2010, the account averaged just $5 billion.

Now that the Congress has raised the debt limit on the government, the plan has been revived.

The original purpose of the Supplemental Financing Account was to get cash into the hands of those that needed funds and not have to go through the market system which would take more time and, perhaps, a greater amount of trading, to meet the peak liquidity demands in the financial crisis. That is, the Treasury had cash to spend out of this account that could go directly to those that needed the stimulus spending. This program allowed the Treasury to issue securities without going directly to the market and perhaps keeping interest rates from falling.

In the present case, the Treasury says that it is going to keep the cash proceeds from the borrowing on deposit at the Federal Reserve. If this is true, then it seems that what the arrangement is providing is more Treasury securities to the Fed to be used as the central bank reduces the amount of excess reserves in the banking system.

On February 17, 2010, the Federal Reserve had a little less than $800 billion of U. S. Treasury securities on its balance sheet. Commercial bank reserve balances, mostly excess reserves, with Federal Reserve banks stood at slightly more than $1.2 trillion.

If the Fed is going to remove reserves from the banking system by open market sales of U. S. Treasury securities, then it needs to have a sufficient amount of them on hand to be a credible seller of these securities.

Although the Federal Reserve is expected to have $1.25 trillion of mortgage-backed securities in its portfolio in March, it is expected that the Fed will not want to sell these off in any large amounts because it does not want to destabilize the mortgage market and force mortgage rates to rise too fast.

Also, the Fed’s portfolio of Federal Agency debt securities is too small, about $165 billion, to help much in any exit strategy.

Thus, adding $200 billion to the Fed’s portfolio of U. S. Treasury securities will bring the total Treasury securities on hand to approximately $1.0 trillion and this may be sufficient to allow the Fed to “undo” its portfolio and reduce the amount of excess reserves in the banking system without having to sell mortgage-backed securities. That is, if the Treasury does not write any checks against its Supplementary Financing Account.

The Fed is attempting to get as much ammunition in place before the “battle to exit” begins. Over the past several months and weeks, the Federal Reserve has moved to position itself to “undo” its massive injection of reserves into the banking system. Last week it announced that it was returning the “primary loan” function to its pre-crisis operating procedures. (See my “Back to Business at the Fed”: This week, the Treasury is pumping up its Supplemental Financing Account. Next week, well who knows.

This process will continue over the following weeks as the Fed does all it can to prepare for its “undoing.”

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