Monday, December 6, 2010

Federal Reserve QE2 Watch: Part 1

Quantitative Easing, Part 2 has begun. As I wrote on November 4, 2010, “The Fed is going to purchase an additional $600 billion in US Treasury securities over the next eight months, or $75 billion per month, in order to get the economy growing again…over the same time period, roughly $250 to $300 billion will run off of the Fed’s mortgage-backed securities portfolio. This $250 to $300 billion in mortgage-backed securities will be replaced by $250 to $300 billion in U. S. Treasury securities. (See "The Fed's $850 billion bet":

The reason given for this policy is that the economy is not picking up fast enough and that unemployment is such a problem that the Fed must act in an extraordinary way in order to correct the situation. Nothing, however, is being said about the weaknesses in the commercial banking sector and the need to put a floor under asset prices so that the banking regulators can work out all the insolvent banks.

So, we are entering a new phase of monetary policy. It is very important to keep on top of what the Fed is doing so that we can try and understand how this quantitative easy is working and what impacts this policy is having on the banking system.

Remember, starting in July 2009, the Federal Reserve began to execute an “exit policy” to remove all of the excess reserves it had pumped into the banking system in the first round of quantitative easing. The Fed, in combating the “Great Recession” pushed the excess reserves in the banking system from about $2.0 billion to over $1.0 trillion. During this time, the balance sheet of the Fed grew from less than $900 billion to more than $2.0 trillion. The “exit policy” was an attempt to return the balance sheet to a size that was comparable to the earlier figure and substantially reduce the excess reserves in the banking system.

During the year or so that the Fed was engaged in its “exit strategy”, the Fed’s balance sheet actually increased and excess reserves in the banking system rose! (See

So much for an “exit strategy.”

Now for QE2! Given the directive mentioned above, there are three areas that we need to keep a close watch on. First, we need to watch what happens to the Federal Reserve balance sheet and what happens to the excess reserves in the banking system. This will tell us whether or not the Fed policy is expansive. Second, we need to watch the runoff in the portfolio of mortgage-backed securities (and Federal agency securities) to see whether or not the Fed is replacing the runoff with purchases of Treasury securities. Third, we need to see what “operational” factors are influencing the Fed’s balance sheet to determine whether or not the purchase of Treasury securities are going to support movements of funds connected with seasonal or other operation factors.

Over the last thirteen week period, Reserve Balances held by commercial banks at Federal Reserve banks actually declined by $2.0 billion.

In terms of the first point, it appears that the Fed did not act to aggressively expand bank reserves or the excess reserves held by the banking system.

In terms of the second point, during this thirteen week period, the Federal Reserve purchased roughly $131 billion in United States Treasury securities. However, the Fed’s portfolio of mortgage-backed securities and Federal agency securities declined by almost $90 billion. The net increase in Securities held outright by the Federal Reserve was more than $40 billion.

Two major “operational” events absorbed bank reserves during this period. These two events caused funds to flow out of the banking system and the Fed needed to inject reserves back into the banking system to replace them. This is what the above $40 billion in securities purchases went to do.

The first “event” that drained reserves out of the banking system was a flow of currency “out of” the banking system. This always happens as people prepare for the Thanksgiving and Christmas holiday seasons: people increase their holdings of cash for current spending purposes. Over the past thirteen week period, Currency in Circulation rose by almost $27 billion and had to be replaced.

The second “event “related to the recapitalization plans of American International Group (AIG). Pending the closing of the recapitalization plan, the cash proceeds from certain asset dispositions will be held by the Federal Reserve Bank of New York as agent. This account appears as a deposit (liability) on the Fed’s balance sheet and results from a flow of funds out of the banking system. Like currency flowing out of the banking system, this movement also has been replaced in the banking system through the Fed’s purchases of U. S. Treasury securities. This account rose by almost $27 billion over the past thirteen weeks.

These were the major changes in accounts over the past thirteen weeks. Other smaller movements of funds provided the balance of getting to the $2.0 billion decline in the Reserve Balances account.

Over all, excess reserves in the commercial banking system declined by about $2.2 billion from the first week in September to the first week in December. Thus, the initial move toward quantitative easing has not resulted in any major change in the banking system, although the Fed’s balance sheet rose by about $45 billion, to almost $2.4 trillion. This rise has occurred due to “operating transactions” relating to the seasonal rise in currency outside of commercial banks and due to the recapitalization of AIG.

So far, the major impact of the QE2 formula is the shift in the overall portfolio of securities held outright by the Federal Reserve. Here we got a major shift from mortgage-backed securities and Federal agency securities to securities issued by the United States Treasury.

We will keep watching.

One final point: I have never seen the Federal Reserve so blatantly political. Fed Chairman Ben Bernanke is now the “point person” for the Obama administration’s economic policy. Never, has a Fed chairman had to go out and sell the government’s monetary and fiscal policy like Bubble Ben has. To me, it’s embarrassing. As reported by Mike Allen in Politico Playbook, the FEDWATCH On 60 MINUTES - CBS News release: “In a rare and frank interview, Federal Reserve Chairman Ben Bernanke talks to Scott Pelley about the troubled economy and the measures the central bank has taken to improve it. Bernanke's interview took place in Columbus, Ohio, last Tuesday (30) and addresses several pressing economic matters..He also talks about the federal deficit and reforming the tax code. He explains why the Fed announced its intention to buy $600 billion in Treasury securities, defending against charges the move will lead to inflation and not ruling out the purchase of more. The Fed chair also addressed the federal deficit.”

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