Monday, September 6, 2010

Federal Reserve Non-Exit Watch: Part 1

Last month I presented Part 13 of my exit watch of the Federal Reserve. In the summer of 2009, the Fed stated that it was going to remove reserves from the banking system to reverse the massive injection of reserves that took place in late 2008 and early 2009.

The Federal Reserve really did not “exit” over this 13 month period. In fact, bank reserves and excess reserves actually increased during that time period. From my post on
August 10, 2010 (see

“Here we are 13 months into the “exit watch” and there has been ‘no exit’ of reserves from the banking system. In fact, Reserve Bank credit is now $331 billion GREATER than it was one year ago; it has grown over the past 365 days by 16.7%, as of August 4, 2010.”

Over the past month, the Federal Reserve has backed off from this policy of removing reserves from the banking system because of the concern over the fragile condition of the smaller banks in the United States and the failure of unemployment to fall. Chairman Bernanke has spoken about the need for the Federal Reserve System to focus on the economy while “the FOMC will do all that it can to ensure continuation of the economic recovery.” This is from the speech he gave at Jackson Hole, Wyoming on August 26 (see my post

Thus, the “Federal Reserve Exit Watch” becomes the “Federal Reserve Non-Exit Watch.”

There are two areas to focus on in this “Non-Exit Watch.” The first relates to all of the “innovations” the Federal Reserve created to bailout various financial institutions (like Bear Stearns and AIG that “blew up” the Fed’s balance sheet) and to engage in “liquidity swaps” with other central banks throughout the world. The plan is for these accounts to decline incrementally as assets are worked off or that the need for central bank liquidity swaps declines.

Over the last four weeks ending September 1, 2010, these Federal Reserve accounts that were created during the financial crisis have declined by $16.4 billion. Central bank liquidity swaps have fallen to almost zero and the other “crisis” portfolios the Fed maintains continue to run off. Still the Fed’s balance sheet maintains more than $150 billion in assets that are connected with the financial upheaval.

Over the past 13-week period these accounts have dropped by a little more than $22 billion. These accounts should continue to decline in the future, but the pace of decline will not be large.

The second area relates to the securities portfolio of the Fed. As a part of its support of financial markets, especially the mortgage market, the Federal Reserve bought substantial amounts of mortgage-backed securities and federal agency securities. A part of the “exit” strategy of the Fed was to let these securities “run off” as they matured thereby helping to reduce the excess reserves held by the commercial banking system.

It appears as if the “non-exit” plan is to replace the maturing mortgage-backed securities and federal agency securities with outright purchases of United States Treasury issues. In this way the Fed will keep funds in the banking system so as to encourage bank lending and economic growth but will reduce the role that it has played in specific sub-sectors of the financial markets.

It appears as if the Fed began this program within the past four-week period. Between August 4 and September 1, the volume of mortgage-backed securities at the Fed dropped off by $14.5 billion and the amount of federal agencies on the books of the Fed fell by $2.9 billion.

United States Treasury securities “held outright” by the Federal Reserve rose by $9.3 billion so that the volume of all securities held by the Fed dropped by only $8.1 billion. Note that this action was concentrated in the last four-week period for this behavior was not observed in the nine earlier weeks of the last 13-week period.

Overall, reserve balances with Federal Reserve banks fell by $27.2 billion over the last four-week period. Part of the drain from the Fed was the seasonal rise in both currency in circulation and bank needs for additional vault cash during the summer to handle the vacation pickup in the demand for currency. These movements result in an increase in factors absorbing reserve funds which reduces reserve balances at Federal Reserve banks. As a consequence, the excess reserves in the banking system remained relatively constant. There are always these “operational” factors occurring that the Fed must take account of in order to help the banking system function as smoothly as possible.

Given what Bernanke and others at the Federal Reserve have said, we must keep our eyes on what the Fed does with its securities portfolio. The Fed does not seem to want to maintain its mortgage-backed securities portfolio or its federal agency portfolio at the levels achieved earlier this year. It appears that the Fed will allow the volume of these portfolios to decline naturally as they mature and run off. The thing to watch is whether or not the Fed replaces this run-off with the acquisition of United States Treasury issues.

The good thing I see about this is that in “normal” times the Federal Reserve has primarily conducted its monetary policy using the Treasury market, either through outright purchases or through the repurchase market. Thus, to reduce the amount of mortgage-backed securities and federal agency securities in its over-all portfolio and to increase the proportion of Treasury securities is, to me, a good thing.

However, even though the Federal Reserve, over time, is going to have to withdraw the excessive amount of reserves it has pumped into the banking system, this is not going to happen in the near term. There was a lot of “bad” economic news that came out in August. This “bad” news had a very negative impact on the polling statistics of the President and created a very dark picture for Democratic politicians looking forward to the November elections. Within such an environment, the Federal Reserve and its officials must appear to be working to accelerate the economic recovery and help put more people back to work.

Thus, the Fed is not likely to allow reserves to decline by much in the banking system, although I doubt that they really want to increase reserves much throughout the fall. For the time being, it looks as if the best bet is that the Fed will let the runoff continue in mortgage-backed and federal agency securities, replacing them with purchases of Treasury securities. This will take place while the Fed allows the “crisis” assets to continue to decline as they are resolved. The only deviation from this picture would occur if the economy or the banking system took a turn for the worse.

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