Federal Resere Non-Exit Watch: Part 3

It is Halloween…is that QE2 I see lurking in the shadows? Oh, my…I’m scared!

Here we are in the third month since the Federal Reserve declared that their program to withdraw all the liquidity they had injected into the banking system was at an end. Of course, during the exit program excess reserves in the banking system rose substantially as total reserves and the monetary base continued to rise.

Funniest “exit” strategy I have ever seen. But, what else can we expect from the current leadership of the Federal Reserve System?

Now the Fed is engaged in a “non-exit” strategy with many analysts believing that the second round of quantitative easy will begin on Wednesday, the day after the mid-term elections. (No politics here!)

In preparation for any changes in monetary policy that might take place in the near future, we still need to get current with how the Fed has been behaving in the recent past.

Over the past thirteen-week period, the Excess Reserves held by commercial banks have declined by about $40 billion. This is consistent with the figures derived from the Federal Reserve data on the Federal Reserve’s H.4.1 release “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.” In terms of the actual data for the end of the banking week, the comparable figure, reserves with Federal Reserve Banks also declined by about $40 billion over the past thirteen weeks.

Over the past four-week period, however, the reserve balances at Federal Reserve banks rose by more than $26 billion, a number we shall examine below. The excess reserves held by banks also rose over this time period.

The banking system still remains very liquid although this seems to be just what the commercial banks want.

In terms of the money stock statistics, monetary growth actually increased at a relatively steady pace over the last thirteen weeks. The most closely watched measure of the money stock, the M2 measure, was rising at a year-over-year pace of 1.8% in July 2010. This year-over-year rate of growth increased to 2.8% in September and stands at about 3.0% near the end of October.

The year-over-year growth rate of the M1 measure of the money stock has also increase steadily into the fall. In July 2010, M1 was increasing at a 4.7% rate. This rose to 5.9% in September and was around 6.3% at the end of October.

Money stock measures are showing steady rates of increase and this is good.

The steady increase in the money stock measures seems to have been little affected by the transactions going on within the Federal Reserve’s balance sheet, and this is good.

The questions that need to be asked is what happened on the Fed’s balance sheet and why?

The first series of questions relates to the $40 billion decline over the past thirteen weeks in the reserve balances held by commercial banks in Federal Reserve banks.

This decline primarily comes from three sources. The first source is a rise in Currency in Circulation of over $19 billion. A movement like this reduces reserve balances as coin and currency is withdrawn by the public from commercial bank accounts. In the last three months the year-over-year rate of growth of currency held by the public has increased from 3.8% to 4.0% to 4.4%. This figure is high relative to the five years before the financial collapse in the fall of 2008 and the fact that it is rising is something to pay attention to. Currency in circulation does not usually go up in the fall season relative to July and August because cash needs are usually high in vacation periods but not in the fall when coin and currency is returned to the banking system.

The demand for cash can rise as people having financial difficulties transfer their wealth into cash balances so that they can pay for the necessities of life. This is not good.

Note that of the $19 billion increase over the last thirteen weeks, almost $9 billion of the increase came just in October. Keep a watch on this number.

The second source of the decline in reserve balances came from accounts on the Fed’s balance sheet related to “bail out” items. Almost $17 billion left the Fed’s accounts related to a decline in these “special” accounts. The Fed plans to allow these accounts to run off as these assets are worked out. Hopefully these accounts will continue to decline at a relatively steady pace.

The third source of decline came in the Fed’s portfolio of securities: specifically, the Fed’s portfolio declined by a little more than $15 billion in the thirteen weeks ending October 28, 2010. Of interest is the fact that the holdings of Mortgage-backed securities declined by more than $66 billion and the holdings of Federal Agency securities declined by almost $10 billion, a total of about $76 billion. The Federal Reserve replaced $61 billion of these securities through the acquisition of U. S., Treasury securities.

Note that the Fed is doing pretty much what it said it would do in this regard. The Fed said that as the portfolio of Mortgage-backed securities and Federal Agency securities declined, it would seek to offset this decline by the purchase of Treasury issues. This is another area that bears close attention in the up-coming weeks.

Finally, we look for an explanation of the $26 billion increase in Reserve Balances at Federal Reserve banks over the past four weeks. The primary mover here is operational in nature. The General Account of the U. S. Treasury at the Federal Reserve declined by about $31 billion during this period. This puts reserves back into the banking system. A movement in this account is usually associated with writing of checks at the Treasury, reducing tax monies that have been collected in the past. The Federal Reserve knows that a movement like this is going to take place and is therefore prepared to deal, operationally, with this drain on its balance sheet.

Very little change took place related to factors supplying reserve funds to the banking system. However, the Federal Reserve continued to see its portfolio of Mortgage-backed securities run off during this period (the portfolio declined by almost $28 billion) and Federal Agency securities (a $4 billion decline) run off. This run off was countered by purchases of U. S. Treasury securities which increased this part of the Fed’s portfolio by $26 billion.

The net decline in the securities portfolio was offset by other small movements in accounts so that factors supplying funds to bank reserves was relatively insignificant.

My interpretation of the actions of the Federal Reserve over the past quarter: basically a holding action. Overall, the money stock measures are showing small but steady increases in growth and this is a positive note. The thing to watch here is how much of the increasing growth rate in the money stock figures is related to a rising use of currency in circulation.

Otherwise, the Fed has been true to its statements (so far) in purchasing U. S. Treasury securities to roughly offset the regular runoff from the Fed’s portfolio of Federal Agency issues and Mortgage-backed securities. Obviously, if Quantitative Easy 2 is executed, the acquisition of Treasury issues will more than offset the runoff of these other securities. Stay tuned!

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 http://seekingalpha.com/article/219717-federal-reserve-exit-watch-part-13):

“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 http://seekingalpha.com/article/222704-bernanke-in-the-hole).

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.

"We don't know what we are doing"--the Fed

The Federal Reserve has two basic problems right now. First, those running the Fed don’t know what they are doing. Second, they are doing a terrible job explaining this to the world.

Never have I seen such confusion in such an important institution. Never have I seen such inadequate leadership.

We have experienced the end of the Fed’s exit strategy, the effort undertaken by the Fed to reduce the size of the Fed’s balance sheet. The exit strategy was designed to reduce the massive amounts of reserves pumped into the financial system by the Fed so that a period of hyper-inflation would not result. That exit strategy saw the Fed’s balance sheet grow by $331 billion over the twelve-month period the “exit” strategy was in place. Excess reserves held by the banking system rose by 38% during the same time period.
(http://seekingalpha.com/article/219717-federal-reserve-exit-watch-part-13)

One can only imagine what the end to the "exit strategy” will mean for bank reserves.

So, the Fed is now not going to let its balance sheet decline. As securities mature it will replace those securities with newly purchased securities. Impact is “net zero” on the balance sheet. If the economic recovery does not pick up steam or if it stalls or even declines, the Fed will purchase even more securities resulting in a further increase in bank reserves.

The reason for this change in focus? Well, the Fed has observed that the economy is moving more slowly than previously thought.

This is the Fed and the Fed leadership that continued to fight inflation as the housing market tanked and financial institutions balanced on the edge of collapse. The Fed seems to have totally missed the August 2007 meltdown of hedge funds failing to act until September 2008. Then, in the fall of 2008, Bernanke panicked and we got the infamous TARP legislation and an inconsistent mish-mash of bailouts that “saved the financial system.” (http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic)

The Fed continues to frame its statements in terms of the weakness of the economy. However, in the statement released after the last meeting of the Open Market Committee the Fed admits that “Bank lending has continued to contract.”

This is all the attention the Fed gives to the banking system; the industry which the Fed supposedly knows intimately? And, this banking system has over $1.0 in excess reserves and is not lending? This banking system that has 775 banks on the FDIC’s list of problem banks? This banking system that Elizabeth Warren claims has 3,000 banks facing severe solvency problems? This banking system that has one out of every 2 banks in it in trouble?

The statements of the Fed just don’t coincide with what people and the financial markets see out in the real world.

There seems to be a significant disconnect between what is going on in the Federal Reserve and what is going on in the world. Damn those econometric models!!!


We got where we are because the Fed didn’t understand what was happening and then threw everything it could against the wall to see what would stick. I fear that we are experiencing déjà vu all over again!

Federal Reserve Exit Watch: Part 12

This is the twelfth edition of the Federal Reserve Exit Watch. The first edition was posted in August 2009. The Great Recession, many contend, ended in July 2009 and, at that time, the major task of the Federal Reserve System appeared to be the task of reducing, as judiciously as possible, the massive amount of reserves that the central bank had put into the banking system to combat the threat that the Great Recession might turn into a second Great Depression.

On July 8, 2009 on the Fed’s balance sheet, total factors supplying reserve funds to the banking system totaled over $2.0 trillion, up from around $0.9 trillion one year earlier. It was September of 2008 when the liquidity crisis hit the financial system in the United States which resulted in the rapid injection of funds into the banking system to protect the system from a series of systemic failures. In July 2009, excess reserves in the banking system average around $750 billion.

The concern at that time was that all of these excess reserves in the banking system would eventually end up in the money stock and this would result in inflationary pressures threatening significant increases in consumer and asset prices.

One year later on July 7, 2010, total factors supplying funds to the banking system amounted to about $2.4 trillion. Excess reserves in the banking system totaled more the $1.0 trillion. Obviously, the Federal Reserve System did not remove reserves from the banking system during the past twelve months.

The reason given for not removing reserves from the banking system is that the economy has remained excessively weak: and the Federal Reserve will not start removing reserves from the banking system until the economy seems to be picking up momentum.

My belief has been that the health of the smaller banks in the banking system, those 8,000 or so banks that are smaller than the 25 largest banks, is still not good and the Fed will not begin to remove reserves from the banking system until these non-big banks get in much better shape. With about one in eight banks in the United States on the problem bank list of the FDIC, the banking system is a long ways from being healthy.

And, the Fed has promised that it will continue to keep its target interest rate close to zero “for an extended period” of time. That is, banks should not be afraid of rising short term interest rates any time soon. Many market analysts don’t expect short term interest rates to begin rising until after the start of 2011.

One crucial thing to understand about the operations of the Federal Reserve over the past 12 months is that the injection of funds into the banking system through the fall of 2008 and into the summer of 2009 consisted primarily of “innovative” efforts by the central bank to provide liquidity to specific parts of the money and capital markets. The reserves injected into the financial system were not anything like the classical operations of a central bank which mainly came from the sale or purchase of U. S. Treasury securities in the open market and discount window borrowings from the district Federal Reserve banks.

A major part of the exit strategy of the Fed related to the reduction in these “special” sources of funds and moving back into more traditional forms of central bank operations. Therefore, in the initial stages of the Fed’s exit strategy, efforts were directed at seeing the “special” sources of reserves decline as their needs receded and replacing the reduction in reserves with the purchase of securities from the open market.

The twist in this effort was that the Fed focused, not on the purchase of traditional source of open market securities, U. S. Treasury issues, but on acquiring a lot of mortgage-backed securities, up to $1.250 trillion worth, in order to provide support for the mortgage and housing markets, and on acquiring Federal Agency issues. On July 8, 2009, mortgage-backed securities on the books of the Federal Reserve System totaled about $462 billion. On July 9, 2010, this total reached $1.1 trillion. Federal Agency issues rose from around $98 billion on the earlier date to $165 billion on the latter date. U. S. Treasury securities rose as well, but only by about $104 billion.

Thus, in this 12-month period, total factors supplying reserve balances rose by $341 billion, and the amount of securities the Federal Reserve bought outright rose by $826 billion. The portfolio purchases replaced a lot of the “special” sources of funds supplied to the banking system by the Fed over the past ten months. This was an important part of the Fed’s exit strategy.

So, in the past 12-month period, the Fed actually increased the amount of excess reserves in the banking system. However, in the last 13-week period, excess reserves have actually fallen slightly. One could strongly argue that the decline in excess reserves has come more from operating factors rather than from any overt efforts to reduce bank reserves.

One cause for the reduction in excess reserves was the increase in U. S. Treasury deposits at the Federal Reserve in the Supplementary Financing Account. This is an account set up by the Treasury Department to specifically help the Fed drain reserves from the banking system. (See my post of April 19, 2010, “The Fed’s New Exit Strategy”, http://seekingalpha.com/article/199444-the-fed-s-new-exit-strategy.) During the past 13-week period this account rose by $50 billion, helping to bring down bank reserves. Other operating factors that drained reserves from the banking system was a $12 billion increase in currency in circulation. Also, reducing reserves was a decline in central bank liquidity swaps that fell by about $8 billion during this time period.

Over the past thirteen weeks, these factors draining reserves from the banking system was offset by about $50 billion in Fed acquisitions of mortgage-backed securities.

The net effect of all factors affecting reserve balances: a $50 billion decline in excess reserves.

Over the past four weeks Federal Reserve actions have remained relatively minor. Excess reserves in the banking system fell by about $19 billion, but this primarily resulted from operating transactions like the increase in currency in circulation and a rise in U. S. Treasury balances in the Treasury’s general account which is usually connected with tax receipts. So the last 4-week period can be considered to be uneventful.

One other thing we need to check in this analysis is the behavior of the M1 and M2 measures of the money stock. All that can be said here is that the growth rate of these two measures continues to be modest and actual growth rates have been achieved by people and businesses re-arranging assets rather than from commercial banks making loans. The year-over-year rate of growth of the M1 measure in June was about 6% while the M2 measure rose by only 1.6%.

Note that the non-M1 component of M2 grew by only 0.6% during this time period. This was because, small denomination time deposits at financial institutions have fallen by more than 22% over this time period and Retail Money Funds have dropped by more than 25%. All of these funds seem to have gone into demand deposits, other checkable deposits, and money market deposits, part of M1. This, as I have written before, is not a sign of health in the economy because people continue to transfer funds out of interest-bearing accounts and into forms of money that can be used for spending. This is a sign of desperation not of an improving economy.

A consequence of this has been that the required reserves at commercial banks have continued to rise so that the Federal Reserve must increase the total reserves in the banking system so as to keep excess reserves constant.

One other measure reflecting this shift in assets: monies in Institutional Money Funds have also fallen by 25% year-over-year.

The conclusion to this Exit Watch report is that the Federal Reserve HAS NOT YET started taking reserves from the banking system. That is, over the past year the Fed has not, if fact, exited. And, people and businesses in the aggregate still need to reduce their portfolios of invested funds in order to have money available for spending on their daily needs.

Federal Reserve Exit Watch: Part 11

The basic monetary facts are these: commercial banks aren’t lending and the money stock measures are not really growing. On the surface, it looks as if we have what Irving Fisher called, in the 1930s, the makings of a debt deflation. This is how we can interpret the statistics from the banking sector.

Contrary evidence comes from the performance of the “big banks”, the largest 25 domestically chartered commercial banks in the United States banking system. They are raking in profits right and left and are “making a killing” from the arbitrage and trading opportunities being subsidized for them by the Federal Reserve System.

The other 8,000 domestically chartered commercial banks in the United States are not doing so well. Roughly one out of every eight of these banks is on or very near the list of problem banks of the Federal Deposit Insurance Corporation. These are the banks that the Federal Reserve is trying to preserve through the low target interest rate policy it is following that is the ‘cash cow’ for the largest banks.

The Federal Reserve got us into this position by following a very destructive monetary policy in the early part of this decade. Then, once the financial system began to collapse, Chairman Ben Bernanke and the Federal Reserve threw everything it had against the wall to see what would stick.

We talk about financial innovation in the private sector! No group, organization, or institution initiated more financial innovation over the past fifty years than did the United States government and the Federal Reserve takes the individual prize for financial innovation during this period for what it did over the last three years or so. But, there was no real sophistication to the Fed’s financial innovation: the task of the Federal Reserve was to throw as much money as it could into the financial markets to protect the ‘liquidity’ of the market and its instruments.

Now the banking system (excuse me, the 8,000 ‘other’ domestically chartered commercial banks) is teetering on the brink of a ‘debt deflation’ (while the 25 large domestically chartered commercial banks are cleaning up) and the Federal Reserve cannot remove whatever ‘stuck’ to the wall from the banking system for fear that the rate of failure of the ‘smaller’ banks will accelerate.

The FDIC is overseeing the closure of approximately four commercial banks a week this year and the feeling is that this rate of failure could rise to five banks a week this summer or next fall. Analysts now expect the Fed will continue its “low interest rate target” into 2011.

Wow! The big banks are going to love this!!!

The ‘other side’ question is how is the Fed going to “get the stuff” that stuck on the wall, off the wall? That is, how is the Fed going to ‘exit’ its stance of excessive ease?

We are still waiting. The only ‘trick’ it has applied so far is to get the United States Treasury to
park funds in something called the “United States Treasury, supplementary financing account.” This account has risen by roughly $200 billion since the first of the year, $175 billion over the past 13 weeks, and this has drained some of the excess reserves from the banking system.

Again, no straight, classical monetary policy: the Fed used gimmicks…whoops, financial innovations…to get us to this point. Looks like we are going to use various gimmicks…whoops, financial innovations…to help get “the stuff” off the wall.

Excess reserves have declined about $80 billion from January, a little over $70 billion in the last 13 weeks, primarily due to the buildup in the Treasury’s supplementary financing account. Excess reserves, however, still are in excess of $1.0 trillion, averaging $1.048 trillion in the banking week ending June 2.

The only thing that the Federal Reserve has continued to do over the past quarter is to continue to increase its holdings of Mortgage-Backed securities. Over the last 13 weeks, the portfolio of Mortgage-Backed securities rose by $87 billion, $16 billion of the increase came over the past 4 weeks.

And, what impact does this seem to be having on the monetary aggregates. Well, the M2 money stock measure is hovering around a 1.6% year-over-year rate of growth. If the expected real rate of growth of the economy is around 3.0% then this monetary growth is certainly deflationary.

But, note this. The rate of growth of the non-M1 part of the M2 money stock measure was only 0.3% in May, on a year-over-year basis. The M1 year-over-year growth rate is 6.8% which shows that people are still transferring their wealth into transactions balances in order to have cash to pay for their daily needs. Given all the unemployment, foreclosures, and bankruptcies, the concern is that this movement will continue putting additional pressure on the 8,000 other domestically chartered commercial banks in the country.

The United States banking system does not seem to be healthy (except for the biggest banks). The monetary system is stalled. Ben Bernanke has traveled to Detroit, Michigan to hold a discussion about getting loans out to small businesses: see his “Brief Remarks at the Meeting on Addressing the Financing Needs of Michigan's Small Businesses, Detroit, Michigan” (http://www.federalreserve.gov/newsevents/speech/bernanke20100603a.htm). The Fed doesn’t seem to understand what is going on.

This is my eleventh post relating to the Federal Reserve’s Exit Strategy. I started these posts 10 months ago because of the concern expressed over how the Fed was going to “get the stuff” off the wall. The Fed wanted to be totally transparent about how it was going to “exit” its position of extreme ease and so it started talking about what it was going to do.

The concern is still there. As far as I can see, there is little confidence that the Fed can safely lead us to the “promised land”, the land of low unemployment, strong economic growth, and little or no inflation.

The Fed has acted with very little subtlety and sophistication over the past decade. Why should we expect it to act any differently over the next ten years, let alone over the next year?

Federal Reserve Exit Strategy: Part 10

In the last “Exit Strategy” post (http://seekingalpha.com/article/196931-federal-reserve-exit-watch-part-9) I stated that the Fed balance sheet was getting boring. Over the last four weeks the Fed’s actions continue to be boring.

In the current circumstances, boring is good when it is connected with the non-existent loan growth in the banking sector.

The major change in the Fed’s balance sheet over the last four weeks in terms of factors that supply bank reserves was an increase of almost $28 billion in mortgage-backed securities.
I know, the Fed said it wasn’t going to buy anymore mortgage-backed securities after March 31…but it did. Who can you trust anymore?

The changes in all other factors supplying reserves to the banking system were basically a wash.

However, there was some interesting movement on the other side of the statement. Of course, April is tax time and so the Treasury cash management activities impact the reserves in the banking system. And, we did see U. S. Government demand deposits at commercial banks build up through the month of April, averaging a little less than $8 billion in the banking week ending April 19. (Through most of the year these balances will average in the $1.2 to $1.8 billion range.)

The government lets these deposits build up at commercial banks during tax time so that reserves are not drained from the banking system. They will only be drawn down as the Treasury pays out of its General Account at the Fed which puts reserves back into the banking system. Usually, during tax time the General Account is allowed to decline.

But, there was something else going on at this time. The Federal Reserve, together with the Treasury Department, is using another government account at the Fed, the Supplementary Financing Account, to drain reserves from the banking system.

For more on this see my April 19 post, “The Fed’s New Exit Strategy” (http://seekingalpha.com/article/199444-the-fed-s-new-exit-strategy).

Since the new federal debt limit was passed in February 2010 the Treasury has been increasing the balance in the Supplementary Financing Account. As a consequence, it is difficult to tell exactly how the Treasury is managing its tax receipts and the bond receipts that are finding their way into this supplementary account. On April 28, 2010, the balance in this account was just under $200 billion, the amount the Treasury indicated it would keep there.

In the last four banking weeks, this account has increased by $75 billion while the Treasury’s General Account has declined by almost $35 billion. Hence, roughly $40 billion in bank reserves were absorbed using this method during this time period.

This is interesting because excess reserves in the banking system reached all time highs in February 2010 and stayed relatively high in March. They have declined since then by about $50 billion.

The reason for the increase in excess reserves in the February period was the Fed’s purchase of
mortgage-backed securities. Over the past thirteen weeks, the holdings of mortgage-backed securities rose by almost $127 billion. In January and February, the reserves created by these purchases went into excess reserves in the banking system.

The excess reserves only began to be drawn down as the Treasury Department started to increase the funds it held in its Supplementary Financing Account after the debt limit was increased by Congress in late February. After that the Treasury increased this account by $25 billion per week until it reached the $200 billion level. Therefore, excess reserves in the banking system dropped during this time period.

Since the Treasury maintained a minimum of $5 billion in this account until the debt limit was raised, the Supplementary Financing Account rose by $195 billion over the past thirteen weeks. The Treasury’s General Account rose by $70 billion during this time so that the net affect was an $120 billion absorption of bank reserves which roughly offset the Fed’s purchase of mortgage-backed securities. As a consequence, excess reserves in the banking system on April 28, 2010 were roughly the same as they were at the end of January.

So, excess reserves in the banking system backed off from the all time highs that were reached during the first quarter. A new tool, the U. S. Treasury Supplementary Financing Account, was used to bring the banking system off of this peak. Now where do we go?

Well, another Fed tool was introduced last Friday, the “Term Deposit Facility” or TDF. (See the press release: http://www.federalreserve.gov/newsevents/press/monetary/20100430a.htm.) Under this facility the Fed would offer deposits with maturities of up to six months to member banks. Presumably deposits in the TDF would receive market rates of interest for the idea is that these deposits would be a positive alternative to commercial banks lending out their excess reserves to businesses and consumers. And, it would be risk free.

The Fed has lots of room to provide competitive interest rates because it earns interest on the securities that it has purchased outright and pays little or no interest on most of the funds it has on deposit. The evidence is the large amount of “excess returns” that the Fed gives back to the Treasury every year. This is the benefit of being able to “print money”.

This facility is intended to “tie up” some of the excess reserves the Fed has put into the banking system so as to prevent the banks from extending credit too rapidly thereby increasing money stock growth and threatening excessive inflation in the future.

This is just one more tool that the Fed has created to help it through the “Great Undoing.” Another tool the Fed said it would rely on is “Reverse Repurchase Agreements.” Of course, there is still the old reliable tool, outright sales of securities. The Fed hopes to use these in coordination with each other in order to not only drain excess reserves from the banking system but, in other ways to tie up the excess reserves so that they will not be used in bank lending. This is not a problem right now but could be in the future.

The Fed has indicated that it is continuing the target Federal Funds rate stance it has followed since December 2008. And, because of the weak economy and the weak banking system it is planning to continue this policy for “an extended period” into the future.

The Fed remains in a precarious position since it is still trying to balance itself between a weak economy and banking system and the fear that the economy will begin to strengthen and bank lending will explode using all of the excess reserves that it has available to it. All we can do is sit back and watch what the Fed is doing and hope that things will remain quiet and boring.

The New Way for the Fed to "Exit"?

Has the Federal Reserve begun its exit strategy? Has the Fed already started the “Great Undoing”? It has, but the new exit movement is not taking place in open market operations…or in repurchase agreements. It is occurring with the help of the Treasury Department. Let’s look at the line item on the Fed’s balance sheet titled “U. S. Treasury, supplementary financing account”.

The Federal Reserve defines the U. S. Treasury, supplementary financing account in this way:

“U.S. Treasury, supplementary financing account: With the dramatic expansion of the Federal Reserve's liquidity facilities, the Treasury agreed to establish the Supplementary Financing Program with the Federal Reserve. Under the Supplementary Financing Program, the Treasury issues debt and places the proceeds in the Supplementary Financing Account. The effect of the account is to drain balances from the deposits of depository institutions, helping to offset, somewhat, the rapid rise in balances that resulted from the various Federal Reserve liquidity facilities.”

Thus, this account is a deposit facility of the Federal Reserve similar to the U. S. Treasury, general account, the account that the Treasury conducts its general business from. Thus, it is a factor “absorbing reserve funds”, or, in other words, placing funds in this account removes reserves from the banking system. Hence, it contributes to the “exit” of the Fed from its inflated balance sheet.

I posted a note on this account on February 24, 2010 titled “The Treasury’s Latest Maneuver With the Fed”: http://seekingalpha.com/article/190404-the-treasury-s-latest-maneuver-with-the-fed. In that note I described what was going on in the following way: “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.

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.”

In recent weeks a lot of activity has taken place in this account. As stated in the post on February 24, 2010, there were $5 billion on deposit in this account.

On March 3, this balance was just under $25 billion. The balance rose to about $50 billion on March 10, around $75 billion on March 17, and near $100 billion on March 24. Again it rose to about $125 billion on April 1, $150 billion on April 8, and $175 billion on April 15.

Obviously, the plan is for this account to increase by $25 billion every week until the Treasury reaches its stated goal of $200 billion in this supplemental financing account.

What impact has this had on bank reserves?

Well, on February 24, factors, other than reserve balances, absorbing reserve funds totaled $1.082 trillion. On April 14, this total was $1.320 trillion, an increase of $238 billion. Reserve balances at Federal Reserve banks declined from $1.246 trillion on February 24 to $1.061 trillion on April 14, a fall of $185 billion.

The latest information we have on excess reserves in the banking system indicates that for the two banking weeks ending April 7, excess reserves averaged about $1.094 trillion, a decline of about $100 billion from the average that existed for the two banking weeks ending February 24 of $1.092 trillion.

Thus, this “maneuver” accomplishes two things. First, it is connected with the issuance of Treasury debt to finance the huge budget deficits of the government. Second, the proceeds of the debt issuance do not stay in the banking system, but are withdrawn and put on deposit at the Federal Reserve so that excess reserves are drained from the banking system.

Therefore, the Federal Reserve, with the help of the Treasury Department, has begun to exit!

One could argue that these reserves are coming out of the banking system willingly. That is, the big concern associated with the “Great Undoing” is that the Fed would take reserves out of the banking system that the commercial banks really wanted to “hang onto.” If this were to take place we might get a replay of the 1937 actions of the Federal Reserve when it took excess reserves out of the banking system that the banks wanted to hold onto which resulted in the contraction of bank lending contributing to the 1937-38 depression.

Removing reserves in this way, with the help of the Treasury, might be a benign way to begin the “undoing” which can then be followed up by more traditional central bank operations using repurchase agreements and outright sales of securities. Also, it takes pressure off the Fed in that open market operations could just focus on the Fed’s holdings of U. S. Treasury securities leaving the Fed’s portfolio of mortgage-backed securities and Federal Agency securities free to just decline by attrition. The Fed has only about $777 billion in Treasury securities in its portfolio and, depending upon how much it needs to reduce the excess reserves in the banking system, would probably not want to be forced to use other other parts of its portfolio in removing these reserves.

So, we observe another financial innovation on the part of the government. Niall Ferguson has argued that, historically, governments have been the biggest innovator when it comes to finance. The reason? Governments have been the largest issuers of debt and have had to be very creative in finding new ways to place debt and to manage debt. Certainly in the last fifty years, governments have shown themselves very adept at coming up with new ways to spend money…and to finance this spending.

Federal Reserve Exit Watch: Part 9

The operating statement of the Federal Reserve is getting downright boring these days. Thank goodness! It brings back memories of the good old days when nobody really cared much about the Fed’s balance sheet or what the Fed was really doing operationally.

I remember calling a friend of mine at the Fed in February 2008. I had a question. There was a new thing called “Central Bank Liquidity Swaps” and I was trying to locate where it was on the Fed’s H.4.1 release, the “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.” At that time, because it was brand new, it didn’t have a separate line item to indicate what the Fed was doing with currency swaps with other central banks. I presumed that the numbers were added into the account “Other Federal Reserve Assets” which had changed substantially in recent weeks and was, formerly, just a miscellaneous collection of a number of different unimportant accounts.

After confirming that the “Other Federal Reserve Assets” contained the information on “Central Bank Liquidity Swaps”, my friend asked me why I was interested in writing about this in my new blog. “Nobody is interested in the Federal Reserve statement. You are just wasting your time!” he said.

Obviously, over the next 24 months or so, a lot of people got interested in the Federal Reserve statement. If we want to talk about financial innovation in the last twenty or thirty years, what happened inside the Fed during this period of time certainly represents some of most important “financial innovation” that took place. To not watch what the Fed was doing with its balance sheet was to miss a large part of the show.

Now, that show is coming to a dull close. Again, we can be very thankful for this. In the banking sector, “DULL IS GOOD!”

First, the Fed had supplied approximated $2.349 trillion in funds to the commercial banking system on March 31, 2010. I estimate that at most $200 billion of these funds are related to the special programs that were created over the past two and one-half years, only about 8.5%. These $200 billion in assets will slowly trickle off the Fed’s statement and will cause very little impact, if any, on the banking system or on financial markets. Good riddance!

Of course, the other $2.1 trillion in funds that the Fed has supplied to the banking system still looms over the financial markets and the economy because almost $1.1 trillion of those funds are residing in commercial bank reserve balances at Federal Reserve banks. In other words, the commercial banking system possesses about $1.1 trillion in excess reserves.

But, the situation is “boring” now because on March 31, 2010, the securities portfolio of the Federal Reserve amounted to slightly more than $2.0 trillion: $777 billion in U. S. Treasury securities; $169 billion in Federal Agency debt securities; and $1,069 billion in Mortgage-backed securities. The removal of funds from the banking system in the Federal Reserve exit strategy, we are told, will come from selling these securities through outright sales or, initially, through repurchase agreements. This is where most of the action will be in the future.

There is another vehicle that the Federal Reserve has cooked up with the U. S. Treasury Department to drain some reserves from the banking system using an account of the Treasury’s at the Fed. This is the “U. S. Treasury, supplementary financing account” and it appears as a liability of the Federal Reserve. (See my post of February which describes this facility: http://seekingalpha.com/article/190404-the-treasury-s-latest-maneuver-with-the-fed.) An increase in this account absorbs funds from the banking system so it can be used to remove reserves along with the Fed operations in its securities portfolio.

At the end of 2009, this supplementary financing account was at $5.0 billion. The Treasury Department had to wait until Congress raised the United States debt limit before it could again rebuild this account. The account has risen by $120 billion since December 30, 2009 and by $100 billion since March 3, 2010. This has helped to keep reserve balances at the Fed relatively constant since the end of the year while the Fed was, at the same time, supplying reserves to the financial markets during this time by buying mortgage-backed securities.

So, in the last 13-week period, the financial markets were relatively calm, the commercial banking system was peaceful, and the Fed did practically nothing except buy $160 billion more mortgage backed securities. The question is, “Is this the calm before the storm?”

No one knows how the “Great Undoing” is going to proceed. The Fed has stopped buying mortgage-backed securities as it promised it would do. There has been some reaction in the financial markets (See “Mortgage Risk Premiums Widen”: http://online.wsj.com/article/SB20001424052702304539404575157612509328610.html#mod=todays_us_money_and_investing.) Mortgage rates have also risen. We are told that “A lot of people are observing what’s going to happen now that the Fed is actually out.”

Now the waiting begins. The Fed has confirmed that it will continue to keep its target interest rate range at current levels for the near term. There are still many uncertainties in the economy that are keeping the Fed from removing the reserves from the banking system and raising its target interest rate range. One of these, of course, is the state of the economy. Economic growth continues to remain anemic, although it seems to be picking up, and the unemployment rate continues to hover around 10.0%.

Furthermore, the health of the banking system, itself, remains questionable as about one in eight banks remain on the problem bank list or near to it. Bankruptcies continue to rise (http://www.nytimes.com/2010/04/02/business/economy/02bankruptcy.html?ref=business) as do foreclosures on homes. We are still waiting to see how the commercial real estate industry works through the next 12 months or so. The Federal Reserve does not want to remove reserves from the banking system if the banking system “wants” to keep those reserves to protect itself during the continuing financial workout period.

The Fed is now as ready as it ever will be to execute its “Great Undoing”. We continue to need to watch the Fed’s balance sheet to observe what the Fed is actually doing with its portfolio of securities and how the Treasury Department is contributing to the removal of reserves through the manipulation of its supplementary financing account.

As with the banking system itself, the thing to hope over the next year or so is for in the actual execution of the Fed’s exit strategy to be accomplished in an orderly fashion. Keep your fingers crossed!

Federal Reserve Exit Watch: Part 8

Looking at the Federal Reserve statistics these days is rather boring. As has been reported over the past month or two, the Fed has gotten its balance sheet in position for the “great undoing.” And, now it is just waiting.

One can divide the Fed’s balance sheet into three components: the “regular” portion which is roughly equivalent to the asset side of the balance sheet of the Fed in the “good old days”; the portion of the balance sheet that consists of line items related to the “new” facilities created to combat the financial collapse; and the “liability” side of the balance sheet which includes Treasury deposits and reverse repos, the account the Fed has stated it will use in the “undoing” of the excess reserves it has injected into the banking system.

The “regular” portion of the Fed’s statement now represents over 90% of the assets of the central bank. Almost $2.0 trillion of these assets are in the form of securities that the Fed has purchased on the open market and holds outright. The only real movement here is in the Fed’s holding of mortgage-backed securities which, on March 3, 2010, amounted to slightly more than $1.0 trillion. The Fed has stated that this account will reach $1.25 trillion by the end of March.

The Federal Reserve has added, net, $175 billion of the mortgage-backed securities to its portfolio over the last 13-week period, roughly $70 billion in the last four weeks.

In terms of the “new” facilities, the Fed is letting these items run off as the assets run off, are written off, or are sold. Over the last 13 weeks, since December 2, 2009, these accounts have declined by slightly more than $100 billion. Over the past month, since February 4, 2010, they have declined by $30 billion.

Overall, therefore, the Federal Reserve has supplied roughly $76 billion to the building of reserve funds over the last 13 weeks and slightly more than $30 billion over the last 4 weeks. Rather a non-event if you ask me.

In terms of factors absorbing reserve funds, the interesting item here is the Supplementary Financing Account of the United States Treasury. I wrote about this account on February 24, 2010 for it seems to be something that the Fed/Treasury is also planning to use during the “undoing”. For more on this see my blog post: http://seekingalpha.com/article/190404-the-treasury-s-latest-maneuver-with-the-fed.

What has happened in this account is that it has been increasing. It reached a low early this year at $5.0 billion, as the Congress had to approve an increase in the federal debt limit. Since February 4, 2010 this account has increased by $20.0 billion. The Federal Reserve announced that an agreement had been reached with the Treasury Department that the Fed will borrow $200 billion from the Treasury and leave the cash on deposit at the central bank. As explained in my post, this borrowing will be used by the Fed to help it “undo” excess reserves in the banking system. It seems as if the Fed is starting to build up this facility slowly so as not to be disruptive to the banking system.

If we combine all the factors supplying reserve funds to the banking system and factors absorbing funds from the banking system we find that commercial bank’s Reserve Balances with Federal Reserve Banks increased by roughly $70 billion in the last four weeks and over the last 13 weeks: thus, very little changed in the banking system over the last quarter of a year.

If we look at the statistics from the banking system itself, we see that excess reserves in the banking system rose by about $110 billion.

What the Fed did, as it has for an extended period of time now, went directly into the excess reserves of the banking system. Commercial banks, as a whole, are just sitting on their hands and doing nothing. This allows the Fed to do all its repositioning in order to prepare for the “great undoing” without throwing any more uncertainty into financial markets.

The Federal Reserve is still “sitting on the fence”. Its dilemma is that the banking system still remains extremely week…except, of course, for the big banks. For more on this see two of my recent posts: “The Struggles Continue for Commercial Banks”, http://seekingalpha.com/article/190191-the-struggles-continue-for-commercial-banks, and, “The Banking System Continues to Shrink”, http://seekingalpha.com/article/188566-the-banking-system-continues-to-shrink. The Fed cannot move too fast to remove excess reserves from the banking system for fear that this “undoing” may result in many more bank failures among the small- to medium-sized banks.

Of course, the economy remains weak and the Fed has used this excuse for not removing reserves from the banking system and raising short-term interest rates. This may be a cover for their real concern over the systemic weakness of the small- and medium-sized banks in the United States.

On the other side there is the continuing fear over the possibility that sooner or later the excess reserves in the banking system will turn into bank loans which will result in an expansion of the money stock measures which will result in a worsening of inflation. With over $1.1 trillion in excess reserves in a banking system that used to carry less than $100 billion in excess reserves there is substantial doubt that the Fed can smoothly remove all of these reserves thereby preventing possible inflation or even hyperinflation. Nothing like this has ever been experienced in history before.

So, we sit and wait.

The good news is that things within the banking system seem quiet now. The FDIC continues to close banks without major disruptions to banking markets or local economies. The focus of financial markets seems to be on Greece, Spain, Italy, the Euro, and California, New York and other political entities. That is good for the banking system!

Some have pointed to a potential problem arising from the sale of assets recently conducted by the FDIC. The argument is that now that these assets have a price, will other banks have to “mark-to-market” similar assets that they carry on their balance sheet? And, if they have to mark these assets to market, will this speed up the number of banks actually failing or force banks that seem to be doing OK into insolvency?

In the circumstances we now find ourselves, boring is good! Let’s hope it stays boring. Or hope that the situation becomes even more boring.

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”: http://seekingalpha.com/article/189547-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.”

The Federal Reserve Exit Watch--Number One

There is great concern about the “Exit Strategy” the Federal Reserve might follow to reduce its balance sheet back to the levels that existed before the “Big Explosion” in the Fall of 2008. I plan to keep an eye on the Fed’s balance sheet over the next 12 months or so to try and keep abreast of what the Fed is doing to return to a more normal operating procedure. I discussed the prospects for a reduction in the Fed’s balance sheet in three posts on June 25, June 29, and July 2. This is just a checkup to see how things have progressed.

Over the past 13 weeks (a calendar quarter) from May 20, 2009 to August 19, 2009, the Federal Reserve allowed the total factors supplying reserve funds to decline by $128 billion. This helped to account for the major part in the decline of Reserve Balances with Federal Reserve Banks which fell by $146 billion. These are the deposits commercial banks maintain at the central bank. Other factors absorbing reserves accounted for the small difference ($18 billion) between these two figures.

The crucial contributors to this decline were all new programs that the Federal Reserve had instituted going back to December 2007 when the first innovations were introduced to relieve the liquidity crisis that was occurring in both the United States and in financial institutions all over the world. For example the amount of funds outstanding connected with the Term Auction Facility (TAF) declined by $208 billion in the May 20 to August 19 quarter. This account reached a peak amount of $493 billion in early March 2009. Currently it stands at $221 billion. This innovation was put into place to get reserves to the banks that needed them as quickly as possible. It looks as if this facility is winding down as the financial markets seem to be operating in a more normal fashion.

Another innovative response to the crisis was the Central Bank liquidity swaps in which the Federal Reserve was able to get dollars out to the rest of the world so as to avoid the problems of resolving pressures that were being felt around the world in converting financial assets into dollars. Over the past 13 weeks, the accounts related to foreign central banks and currency holdings dropped by $166 billion, another massive movement. These accounts had gotten up to around $390 billion in February of this year and on Wednesday August 19 totaled around $70 billion: another facility that seems to be winding down.

Another line item that seems to be going out of business is the Commercial Paper Funding Facility. This account dropped by $103 billion in the last quarter. This facility supported the commercial paper market and its dealers.

So, these three line items, created under the pressure of the financial crisis beginning in December 2007, have accounted for a reduction of about $477 billion of assets on the Federal Reserve’s balance sheet in the last 13 weeks. And, the declines were still continuing in the past 4 weeks so the runoff has not stopped. The figures here show that the TAF declined about $17 billion in the last 4 weeks while the Commercial Paper Funding Facility dropped $56 billion and the Central Bank facility dropped about $29 billion during the same period.

What has changed because the Total Factors Supplying Reserves only fell by $128 billion?

Well, the Federal Reserve is conducting open market operations again, seemingly to keep longer term interest rates from rising and to provide liquidity support to the mortgage backed securities markets. Securities held outright by the Federal Reserve rose $366 billion in the 13 weeks ending August 19! The biggest increase came in the Fed’s holdings of Mortgage Backed Securities, an increase that totaled $178 billion. The Fed also added $153 billion to its holdings of U. S. Treasury securities and $35 billion to its holdings of Federal Agency securities.

Over the last four weeks the Fed increased its holdings of Mortgage Backed securities by $64 billion, its holdings of U. S. Treasury’s by $43 billion and its holdings of Federal Agency securities by $9 billion.

The bottom line is that the Federal Reserve is allowing the special facilities created during the height of the financial crisis to run off but is substituting purchases of open market securities to keep bank reserves at high levels. Reserve balances with Federal Reserve Banks stood at $805 billion on Wednesday August 19, the vast majority of the reserves being just “Excess Reserves” in the banking system.

The philosophy behind this? The Federal Reserve is “exiting” the special facilities it has created to get the financial system through the crisis. However, it cannot “exit” the banking system by allowing those reserves to leave the banks.

An error was made in 1937. Commercial banks were maintaining large amounts of excess reserves at that time. As at the present time, banks were attempting to get their balance sheets in order, were not lending, and were trying to work off bad loans. The Federal Reserve, seeing all of the excess reserves, RAISED reserve requirements. This resulted in another collapse of the banking system, a collapse in the money stock, and a second period of economic disaster for the U. S. economy to follow the 1929-1933 depression.

The Federal Reserve does not want to create another crisis as it did in the 1937-1938 period. My guess is that the Fed will continue to support the large quantity of excess reserves that exists within the banking system until the commercial banks to start lending again.

Thus, it appears that the concern about an “exit” strategy is not going to be about the shrinking of all the innovative lending facilities that the Fed created to combat the liquidity crisis of the recent financial collapse. It appears as if the Fed is going to substitute open market operations to replace the decline in reserves resulting from the working off of these facilities in order to maintain the high level of excess reserves that currently exist in the banking system. Therefore, the concern about “exit” strategy is going to be connected with the removal of bank reserves from the banking system when the commercial banks begin lending again.

It is going to be interesting to see how the Fed will reduce its securities portfolio by $700 to $800 billion at that time!