Monday, January 10, 2011

Federal Reserve QE2 Watch: Part 2

The second application of “Quantitative Easing” on the part of the Federal Reserve System has now been on the books for several months. So, what has been going on at the Fed over this period of time?

One difficulty in examining the period running from the middle of November to the first of January is the “operating” factors that impact bank reserves due to the holiday season and end of year activity.

One such operating factor is that individuals and businesses build up their cash holdings seasonally in order to meet the needs of the holiday purchases. The Fed usually supplies this currency “on demand.”

In addition, due to pending government disbursements, the United States Treasury usually builds up its General Account at the Federal Reserve, the account the Treasury writes checks against.

In the four week period ending January 5, 2011, currency outstanding rose by almost $3 billion and the General Account of the U. S. Treasury rose by $86 billion, a total of $89 billion in reserves that the Fed had to replace in the banking system through its purchase of securities. These were all “operating factors” the Federal Reserve had to deal with.

In the thirteen weeks ended January 5, 2011, currency outstanding rose by about $22 billion and funds in the Treasury’s General Account rose by $56 billion. Furthermore, there was an accounting adjustment related to the AIG bailout operation which withdrew another $27 billion from the banking system in the third quarter of 2010 that also was replaced by the Fed’s purchase of securities, bringing the total of off-setting Fed purchases during this time period to $105 billion.

Therefore, the “net” purchases of securities held outright by the Federal Reserve rose by almost $50 billion over the last four weeks, and rose by about $120 billion over the last thirteen weeks.
As a consequence, commercial bank Reserve Balances at Federal Reserve banks decreased by $28 billion over the last four weeks but rose by around $33 billion over the last thirteen weeks. (Totals don’t add precisely because of other “operating” factors, but these are minor relative to the major changes that I have highlighted.)

The net effect of Federal Reserve operations on bank reserves over these time periods has been relatively minor: consequently excess reserves held by commercial banks remained relatively steady.

On the other hand, the significant QE2 changes in the Federal Reserve’s balance sheet have come in the composition of the Fed’s portfolio of securities held outright. In the last four weeks ending January 5, 2011, the holdings of mortgage-backed securities and Federal agency holdings fell by $31 billion. The Fed’s holdings of U. S. Treasury securities rose by about $81 billion, hence the total amount of securities held by the Fed rose by almost $50 billion, as reported above.

Over the last thirteen weeks, the portfolios of mortgage-backed securities and Federal Agency securities dropped by slightly more than $93 billion while the holdings of U. S. Treasury securities rose by $212 billion. Total securities held outright by the Fed increased by almost $120 billion, as reported above.

I would argue that up to this point in time, quantitative easing has had very little impact on commercial bank reserves and consequently on changes in liquidity or bank lending. Mostly, the Fed has just replaced maturing Federal Agency issues and maturing mortgage-backed securities with Treasury securities. Otherwise, much of the Fed’s operations during this time have been “operational” in nature.

Now, let’s step back a bit, since we are at the beginning of a new year and review what happened to the Fed’s balance sheet over the past year.

Reserve Balances that commercial banks hold at Federal Reserve banks rose by only $9 billion from January 6, 2010 to January 5, 2011. Not much change for all the talk going on about the Fed’s actions.

The question then is “what was the most significant change that took place on the Fed’s balance sheet during the year?”

My post of April 9, 2010 discussed a new strategy for getting reserves into the commercial banking system. This “new” strategy had to do with the creation of something called the U. S, Treasury Supplementary Financing Account. (See my post “The Fed’s New Exit Strategy?”:

Well, the Treasury's Supplementary Financing Account increased by $195 billion in the calendar year of 2010. This account “absorbs” bank reserves, in the same way that moving funds from Treasury Tax and Loan accounts at commercial banks into the Treasury’s General Account at the Federal Reserve transfers bank reserves. Thus, to replace these reserves, the Federal Reserve had to buy securities in the open market to “supply” bank reserves. This, in essence, is “printing money” to substitute for the Federal Debt.

After taking into account other transactions, the Fed supplied about $202 billion in reserves to the banking system which offset a net $193 billion in factors “absorbing” reserve so that commercial bank reserve balances at the Federal Reserve only rose by the $9 billion stated above.

Excess reserves in the commercial banking system actually fell from December 2009 to December 2010 by about $67 billion. Given that excess reserves averaged around $1.0 trillion for most of 2010, the $67 billion drop does not seem particularly significant. The decline did not seem to have much impact either on bank lending or on money market interest rates.

Excess reserves may have fallen during the year because banks needed more required reserve to cover the continued shift in deposits within the financial system from time and savings accounts to demand deposits and other checkable deposits. My last comments on this phenomenon were posted on December 8, 2010: “America Continues to Go Liquid” ( This shift in funds results in an increase in required reserves because banks have to hold more reserves behind demand deposit accounts and fewer reserves behind savings deposits.

It can also be noted that Americans continued to decrease their holdings of Retail Money Funds” (about $30 billion since September 2010) and Institutional Money Funds (about $50 billion over the same time period). Low interest rates and the need to be liquid seem to be dominating the asset holdings of many.

The Fed’s Quantitative Easy in supposed to keep longer term interest rates low so that the economic recovery can accelerate and unemployment can be brought down. The yield on the ten-year Treasury security was around 2.40 percent in early October before the specifics of QE2 were announced. Over the last two weeks this security has been trading around 3.40 percent. Optimists are claiming that this rise in rates is a good sign, a sign that the economy is getting stronger and that inflationary expectations are beginning to grow.

Guess I am not that confident. My experience is that you cannot force long term interest rates below where the market wants them and then maintain them at this lower rate without continually increasing the liquidity being forced into the system. Otherwise, these interest rates will tend to rise of their own volition. At this time I have not seen the Fed actually propping up the financial markets with the “new wave” of liquidity needed to maintain the lower long term rates attained in late summer.

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