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.

Bernanke's Testimony: Reading Between the Lines

Chairman Ben Bernanke gave testimony this past week on the Fed’s semiannual report on monetary policy to the United States Congress. I believe that Mr. Bernanke’s report can be summarized in two sentences. First, the United States economy is recovering, but the recovery will be quite slow. Second, the Federal Reserve will continue to keep its interest rate target at current levels.

This testimony came during a time in which the Federal Reserve has been attempting to reveal and explain how it plans to exit from its current position, a position that includes a banking system with almost $1.2 trillion in excess reserves. Fundamentally, the Fed is ready to begin to “undo” what it has done over the last year and a half. (See, for example, my posts http://seekingalpha.com/article/189547-back-to-business-at-the-fed, and http://seekingalpha.com/article/189547-back-to-business-at-the-fed.)

The implicit contradiction in all of this is that the Fed’s “undoing” is to take place as the economy recovers, but, the Chairman in not willing give a hint as to when the economy will be strong enough to allow the Federal Reserve to start raising its current target level of the Federal Funds rate.

To me, the message that is being conveyed between the lines is that there are still some things so wrong with the economy (that the Federal Reserve is aware of) that the Fed cannot take a chance, even give a hint of a chance, that the target Fed Funds rate will be raised.

And, what is the basis of this fear?

Will, we can start with the state of the banking system. The Federal Deposit Insurance Corporation (FDIC) produced its quarterly report last week and indicated that 702 commercial banks were now on the list of problem banks at the end of 2009. This is up from a total of 552 banks that were on the problem list at the end of September 2009. And, the FDIC closed 2 to 3 banks per week during the fourth quarter of the year.

Given the current list, the expectation is that about 235 banks, one-third of the current total on the problem list, will close over the next 12 to 18 months, a rate of 3 to 4.5 banks per week for this time period.

Remember that there are about 8,000 commercial banks in the United States, with the top 25 accounting for well over one-half the assets in the banking system. Thus, the banks that are failing tend to be small and they tend to be “local” in nature and a failure can cause quite a disruption on “Main Street.”

The problems in the banking system go deep. The insured banks charged off 2.9% of outstanding loans in the fourth quarter of 2009. This is the largest charge off rate in the 75-year history of the FDIC.

At the end of the fourth quarter, 5.4% of all loans were at least 90 days past due, a near-term high. Specific areas of the loan portfolios are showing a large amount of stress. For example, data on construction loans to build single-family loans indicate that about 40% of the loans are either delinquent or have totally been written off. Mortgage loans still remain a problem where about 12.5% of the loans outstanding are past due.

Commercial real estate loans are the looming giant in terms of providing dark clouds for future bank loan performance. Elizabeth Warren, head of the Congressional team that oversees the TARP funds has stated that about 3,000 commercial banks face the possibility of a “tidal wave” of commercial real estate loan problems. At the end of the fourth quarter of 2009, over 6% of these loans were classified as a problem in some way.

Before these problem loan areas can be resolved, the economy must begin to get stronger, people must return to good paying jobs, and real estate values must cease falling. Discouraged workers must return to the workforce and manufacturing firms must increase the utilization of their resources. There is little evidence to indicate that these factors are, in fact, improving to the extent needed to strengthen the loan portfolios of commercial banks.

The Fed, obviously, has a good seat to observe all of these facts. And, I believe, they are very, very concerned. And, I also believe, that bankers are very, very concerned.

Why?

Because the bankers are sitting on their hands and holding onto any type of asset that will not deteriorate in value…cash or deposits at Federal Reserve banks and short term government securities.

Yes, we can say that businesses and homeowners with very good credit are not borrowing. And, we can say that consumers are not borrowing.

I don’t think this is the answer.

I believe that this situation is more like the one that was experienced in the period around 1937. Commercial banks were holding a lot of excess reserves at that time too. Also, there was no lending to speak of during that period. And, the Federal Reserve raised reserve requirements to “sop up” those excess reserves.

And, what did the banks do at that time? They withdrew even further. The banks wanted those excess reserves. They did not want to lend them out. They just wanted the protection and security of having those reserves in their hands. By taking the reserves away, the Fed caused the banks to restrict credit even further in order to return excess reserves to a level more consistent with the safety the banks wanted on their balance sheets.

Ben Bernanke, the student of the 1930s, knows what happened back then. He is, therefore, fighting on two fronts in the current climate. First, there are those that are afraid that the excess reserves the Fed has injected into the banking system will eventually be lent out and this will cause the money stock to expand and this, given the size of the $1.2 trillion level of excess reserves, will result in a higher than desired level of inflation in the United States economy.

Bernanke and the Fed must do enough, talking and maneuvering, to satisfy this crowd. Hence the exit strategy and the efforts to get Federal Reserve’s operations back into a more normal environment.

Second, however, is the fear that the excess reserves in the banking system are “desired” by the banking system and any effort to substantially reduce them in the near future could lead to a further contraction in the banking system that would ensure a “double-dip” Great Recession.

My guess is that Bernanke is not willing to take a risk on generating a further contraction in the banking system by removing bank reserves at this time. This, to me, is the message between the lines of the Chairman’s testimony in front of Congress this past week.

The Fed is ready for the great “undoing” of its balance sheet, but is not going to begin this “undoing” until it is sure that the commercial banks are willing to let go of the $1.2 trillion in excess reserves.

"Fed to Bare Tightening Plan"

I would recommend reading the article by Jon Hilsenrath with the title “Fed to Bare Tightening Plan” which appeared on the front page of the Wall Street Journal February 8. (http://online.wsj.com/article/SB10001424052748703427704575051442884515742.html) In this article Hilsenrath discusses the issues and possible actions the Fed may face in “credit tightening…once the Fed decides the economy has recovered sufficiently.” This is a good follow-up piece to my post of February 7 titled, “Everything is in Place: Federal Reserve Exit Watch Part 7.” (http://seekingalpha.com/article/187265-federal-reserve-exit-watch-part-7)

The problem facing the Fed?

Hilsenrath lays it out: in the financial crisis “the Fed took extraordinary action to prevent an even deeper recession— pushing short-term interest rates to zero and printing trillions of dollars to lower long-term rates. Extricating itself from these actions will require both skill and luck: If the Fed moves too fast, it could provoke a new economic downturn; if it waits too long, it could unleash inflation, and if it moves clumsily it could unsettle markets in ways that disrupt the nascent economic recovery.”

This week in testimony before the House Financial Services Committee, Chairman Bernanke is expected to begin laying out a blueprint of how the Fed expects to undo this “extraordinary action.”

The Fed has a major new tool to use in this “undoing”. This tool is something called “interest on excess reserves” which the Congress gave the central bank in October 2008. In essence, this is interest paid for doing nothing! Right now, just for holding the $1.1 trillion in excess reserves the Federal Reserve has freely given the banking system, the banks receive the interest rate of 0.25%, which is above the effective Federal Funds rate that has been around 12 basis points for a very long time.

The Federal Reserve doesn’t want the banking system to lend out this $1.1 trillion so the idea is, when the Fed is ready to start its “undoing”, it will raise the interest rate paid on excess reserves. This would, hopefully, make it more desirable for the banks to retain the excess reserves than to lend them out to businesses or consumers, thereby inflating credit and the various measures of the money stock.

In essence, the Fed has printed $1.1 trillion in bank reserves and it will subsidize the banking system whatever it takes to keep them from becoming too aggressive in their lending.

Let’s see…the government wants the banks to begin lending again…but, the Fed doesn’t want them to be lending.

Makes a lot of sense!

As Randy Quaid stated in “National Lampoon’s Christmas Vacation,” this is “the gift that keeps on giving.” Suppose I give you $1.1 trillion dollars and then let me pay you 25 basis points, 50 basis points, or whatever it takes for you not to go out and use that $1.1 trillion in any other way. Sounds like a pretty good deal. But, as we know, the Fed has lots and lots of profits from which it can pay this interest.

What is it we are doing for Main Street amongst all the deals we are giving Wall Street?

What about the Fed’s portfolio of securities purchased outright? As of Wednesday, February 3 the total portfolio amounted to $1,912 billion. Of this total, $777 billion were in U. S. Treasury securities. In the near future, this account will bear the burden of asset sales to reduce bank liquidity. Initially, the proposed methodology to achieve these sales is through “reverse repurchase agreements” or “reverse repos.” This is discussed in my post mentioned above.

But, the Fed hopes to have$1.25 trillion in mortgage-backed securities on its balance sheet by March 2010. Last Wednesday, it held $970 billion in its portfolio. It seems as if these securities are NOT going to be available for sale for a while because of the precariousness of the mortgage market and the housing market. The Fed certainly doesn’t want to do anything either in terms of dramatically higher interest rates or lack of liquidity in the mortgage market to disturb a recovery in housing. Don’t count on these securities being used to reduce the $1.1 trillion in excess reserves in the early stages of Fed tightening.

The Fed also has $165 billion in Federal Agency debt securities. Don’t expect these securities to be an active part in the Fed’s “undoing.”

Thus, it seems as if the prescription for the “undoing” is to sell U. S. Treasury securities, first through “reverse repos” and then through outright sales if the banks are congenial with a reduction in reserves and to pay interest on excess reserves to keep banks from lending out their “excess reserves” should loan demand increase or if the banks are not congenial with a reduction in reserves.

How much comfort does this “blueprint” give me?

Not a whole lot!

The Greenspan/Bernanke Fed gave us excessively low interest rates from late 2001 into 2005 (the effective Federal Funds rate was below 2.00% for all of this time period); “measured” rate increases ran into 2006 (Hilsenrath introduces one of the problems with this approach in his article. Rate increases that are “too” predictable can “fuel a borrowing boom” because of the predictability of the rises.); Bernanke publically claimed that there were no problems in the housing market and in subprime mortgage lending during this time period; the Bernanke Fed failed to foresee the economic downturn which began in 2007, but also had no clue to its potential severity; and, to combat the financial crisis, the Bernanke Fed followed one rule and that was to throw everything it could into the financial markets so as to err on the side of providing too much liquidity.

I see very little understanding of financial markets in this performance and no exhibition of “touch” in these actions. It does not leave me with a great deal of confidence that the “undoing” will proceed smoothly. My guess right now is that the Fed will wait too long to begin the “tightening” and that will put them into a world in which none of the actions that are available to them are desirable…much like the fiscal policy stance of the U. S. government right now. This is a problem, however, that one experiences because of the excesses in the past.

Everything is in Place: Federal Reserve Exit Watch Part 7

Looking at the Federal Reserve figures for Wednesday, February 3, 2010, one could argue that just about everything seems to be in place for the Fed to execute its exit plan. The Fed will still purchase some more Mortgage-backed securities and there are some other residuals left from the world financial crisis that still remain, but these are now relatively minor parts of the picture.

On Wednesday, February 3, 2010, the Total Factors Supplying Reserves to the banking system totaled $2,231.3 billion or a little more than $2.2 trillion. The Securities held outright by the Federal Reserve amounted to $1,911.6 billion or approximately 85.7% of the total factors supplying reserves.

To put these numbers in perspective, on Wednesday, December 5, 2007, Total Factors Supplying Reserves to the banking system equaled $920.4 billion and Securities held outright amounted to $779.7 billion or 84.7%. The Fed did have outstanding $46.5 billion in repurchase agreements which, if included, made about 89.8% of their balance sheet related to securities.

On February 3, 2010,the Federal Reserve had no repurchase agreements outstanding.

I go back to December 2007 because one has to go back that far to get to a Fed balance sheet that does not include “special” line items that were constructed to combat the financial crisis. In December 2007, the Term Auction Facility (TAF) was initiated. During the time the TAF existed total funds supplied through this facility reached several hundred billion dollars. On Wednesday February 3, 2010, funds supplied to the banking industry through the TAF were only $39 billion, down $37.4 billion over the past four weeks and down by $101 billion in the last 13-week period.

In preparing to remove excessive amounts of reserves from the banking system the Federal Reserve has been allowing the “special” facilities that have supplied reserves to banks to “run off” while the Fed has replaced these funds with open market purchases.

Another area in which this has taken place has been in central bank liquidity swaps. This facility was also started in December 2007. At one time central bank liquidity swaps were in the hundreds of billions of dollars. On Wednesday, February 3, swaps totaled $100 million.

In the last four weeks and the last 13-weeks, the other items on the Federal Reserve statement did not change dramatically. To me what I have presented in the last three paragraphs pretty well sums up what the Fed has been doing to get itself ready to begin removing excess reserves from the banking system…when it decides it is time to do so.

Over the past 13-week period, reserves have been removed from the banking system by a reduction in funds available through the TAF ($101 billion) and through a decline in central bank liquidity swaps ($32 billion) or a total of $133 billion.

During this time, the Federal Reserve has purchased open-market securities of $214 billion. Thus, total factors supplying reserves during this time rose by $81 billion from these factors.

Over the past 4-week period, the TAF has been reduced by $38 billion and central bank liquidity swaps declined by $10 billion or a total of $48 billion.

Federal Reserve purchases of open market securities totaled $66 billion. Total factors supplying reserves from these factors rose by roughly $18 billion.

I have not discussed the factors that have been absorbing bank reserves over the past 4-week and 13-week periods because they have been impacted by some wide swings in the deposits of the federal government, much of which are technical in nature. And, these factors should not play any important role in how the Fed removes reserves from the banking system.

The bottom line in this discussion is that it seems to me that the Fed has basically eliminated or reduced most of the facilities that it created over the past two years that can have a major impact on the creation or destruction of bank reserves. The two major facilities are, of course, the TAF and central bank liquidity swaps.

The Federal Reserve now has one thing to work with in withdrawing reserves from the banking system: its portfolio of open-market securities. The Fed’s balance sheet is composed of roughly 85% open-market securities held outright. (A shown above, as a percentage of the balance sheet this is not too far off what the composition of the balance sheet was in early December 2007.)

The Fed has already had some recent test runs using “Reverse Repurchase Agreements” (reverse repos), or, selling securities to securities dealers under an agreement to repurchase. The idea here is to test the market’s reception to the withdrawal of funds from the banking system. Since the reverse repos are only temporary, the funds withdrawn will be put right back into the system avoiding any disruption that might be caused by the sale of the securities.

In this way, the Fed can “feel” its way toward withdrawing the excess reserves from the banking system. On one side is the question about is how the Fed will react to a pickup in bank lending and a rapid rise in the growth rates of the money stock. On the other side, the Fed wants to avoid a catastrophe like the 1937-1938 period in which reserve requirements were raised at a time when banks seemed to have had a lot of “excess reserves” on their hands, but really wanted to keep excess reserves on their balance sheets.

Bernanke, a historian of the Great Depression knows this lesson all too well. That is why a suggestion like that of Andy Kessler, a former hedge fund manager, which appeared in the Wall Street Journal last Thursday morning, “Bernanke’s Exit Strategy: Tighten Reserve Requirements” (http://online.wsj.com/article/SB20001424052748703699204575017462822204340.html#mod=todays_us_opinion) seems a bit absurd.

My belief is that Mr. Bernanke and the Fed are going to, at least initially, take things slow. When they begin to exit they are going to engage in some reverse repos and see how the banking system reacts. Then they will do some more…and then some more. The strategy: basically stepping out into the river to see how deep the water is. And, then stepping out a little further…and then a little further. The hope is to avoid falling in over their head, causing a further contraction in the banking system that would lead to another financial crisis.

In doing this the Fed keeps the reserves in the banking system if the economy remains slow or if the banking system wants to hold onto the funds. However, in this plan they start to remove the reserves, testing the market all along the way, so as not to pull the reserves out too quickly.

The problem is on the “up-side”. If bank lending does start to accelerate then the banks will want those “excess reserves” for loans. And, the funds are already on their balance sheets. In such a case the questions will be “How fast will the Fed sell the securities on its balance sheet?” and “How high will the Fed drive up interest rates in order to avoid a credit inflation from breaking out in the United States?”

As we have seen in other periods of time, we can simultaneously be in a period of economic stagnation and still experience a credit inflation. Bernanke has not earned his “star” yet! He still has $1.1 trillion of EXCESS RESERVES in the banking system that must be removed.

Federal Reserve Exit Watch: Part 6

Debate seems to be picking up about the Federal Reserve exiting its current policy stance. Last week Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, and Charles Plosser, President of the Federal Reserve Bank of Philadelphia, spoke last week of the forthcoming need to wind down the Fed’s position. Hoenig said that the Fed should end its purchase program of mortgage-backed securities and Plosser talked about the recovery being sustainable even as existing fiscal and monetary stimulus programs recede.

Still, economists are pessimistic about when the Fed will begin to raise its target for the Federal Funds rate. The effective Federal Funds rate in recent months has averaged about 12 basis points. Bloomberg News conducted a survey of economists’ expectations and the median forecast was for the target rate to remain unchanged through September 2010 and then rise by a half of a point in December 2010.

Since the Federal Reserve finally realized in 2008 that there was a financial crisis and began to combat the unfolding chaos, the basic policy of the Fed has been to throw whatever it can at the wall so that a sufficient amount of what is thrown will stick so that a financial collapse can be avoided.

Can people who devised such a policy really be expected to move its target rate up until it is far past the time that a rise is needed? And, the Fed will then face a situation in which rising interest rates will put many holders of Treasury securities and mortgage-backed bonds underwater and the question will then be, “Can the Fed afford to raise interest rates too swiftly because of all the losses it will create?”

Right now, the Fed is subsidizing the profits of the large banks (and not the small- and medium-sized banks) by its interest rate policy (of course, the Obama administration has threatened to tax away a good deal of the profits). It is just amazing the contradictions in monetary and fiscal policy that are coming out of Washington, D. C. these days. Confusion reigns!

It is no wonder that businesses and banks don’t want to do much of anything these days. They don’t know what the economic policy and regulatory environment will be in three years, let alone three months.

Anyway, the Federal Reserve continues to add reserve balances to the banking system. In the past 13-week period ending Wednesday, January 13, 2010, the Fed has added about $84 billion in reserves to the banking system.

Remember in August 2008 when the total reserves of the whole banking system were only about $44 billion!

Of this $84 billion, $62 billion was put into the banking system in the latest 4-week period.

The major contributor to this increase was security purchases by the Federal Reserve in the open market. In the latest 4-week period, the Fed added almost $71 billion to its securities portfolio bringing the total new purchases for the last 13 weeks up to $233 billion.

A large portion of this increase went to offset the decline in several of the special facilities set up to handle the financial crisis. For example, the amount of funds supplied the banking system through the Term Auction Credit facility fell by about $80 billion over the 13-week period, by $10 billion over the last 4 weeks.

The swap facility with foreign central banks also continued to decline dramatically, falling by almost $38 billion in the latest 13-week period and by about $9 billion in the last four weeks.

In total, it appears as if the funds supplied the banking system through special financial crisis facilities fell by $42 billion over the past 13 weeks and by only $2 billion over the last two.

Thus, the Federal Reserve continues to let these special facilities wind down, replacing them in the banking system through open market purchases.

In terms of preparing for the Fed’s exit, there has recently been trading in reverse repurchase agreements with dealers, but there was no “practice” activity in the past four weeks presumably because of the seasonal Thanksgiving/Christmas churning in the banking system.

As of Wednesday, January 13, 2010, the Federal Reserve held $969 billion in mortgage-backed securities in its portfolio. The central bank has authorized purchases of up to $1.25 trillion going into March of this year. As mentioned earlier, there seems to be substantial debate within the Fed as to whether or not this program should reach the maximum total. We shall see.

The Fed now holds $777 billion in Treasury securities and $161 in the securities of Federal Agencies.

So, the Fed Exit watch continues. So far, the Federal Reserve has honored the path that it started out on: purchasing securities to add to its portfolio thereby replacing the funds draining away from the special facilities created to combat the financial crisis.

Obviously, the real test has not begun. Within the next month or two, if the recovery continues, the Fed is going to come under more and more pressure to start raising its target rate of interest. Until then, big banks will continue to arbitrage the Treasury market and the carry trade will continue to prosper. This behavior is based on the assumption that the Fed is not going to let short term rates rise for a while.

When this assumption is broken, expectations will have to be reset and there will be a re-adjustment in the financial markets as investors exit their arbitrage positions.

What the Fed does then remains to be seen.

However, by maintaining its current policy stance, if the economy doesn’t recover or goes into a double dip recession, the Federal Reserve cannot be accused of aborting the upswing by raising its target interest rate too soon.

The Problem with Debt

The economy is recovering. The areas that seem to show the most life are those sectors that have had sufficient debt relief so as to be able to move forward. The big banks are moving out in a very robust fashion, just how robust we will begin to hear this week. The auto industry seems to be moving ahead, albeit a little more slowly than the big banks. And, there are other areas that show signs of moving forward, the health industry and firms in the information technology industry.

The big cloud hanging over all of this is the debt that still is outstanding in many sectors of the economy. The problem with debt is that it just won’t go away. Regardless of any adjustments made to who owes what to whom, if there is debt outstanding, someone has to pay for it in some fashion.

The big banks were saved, but who picked up the tab for the bailout? The taxpayer did, or, at least the taxpayer has footed the bill pending a potential Obama tax on the banks to “recover” some of the bailout monies.

Who saved the auto industry and subsequently holds the IOU for the rescue? A large part of the financial restructuring came at the expense of those that had provided credit or equity funds to the car companies. And, the federal government also paid a share.

If homeowners got relief from their mortgage and consumer debt, who would pay the bill? Shareholders of the bank, holders of mortgage-backed securities, and the federal government. (You might check out this little piece by Peter Eavis in today’s Wall Street Journal: http://online.wsj.com/article/SB20001424052748704081704574652660161217386.html#mod=todays_us_money_and_investing.)

And, what about the debt that is related to commercial real estate lending? Shareholders of banks, holders of commercial mortgage vehicles, and the federal government.

Then we move to the financial problems of the states. Recent information points to the fact that 36 states in the United States are having financial problems and these could lead to deficits in the state budgets of around $350 billion this year and next. Where is the money going to come to pay for these shortfalls? States have already attempted to sell off properties, outsource functions to the private sector, and even turn some things over to the federal government.

Part of the problem here is that the tax base in most states has collapsed as unemployment and under-employment have risen, as property values have fallen, and as business earnings have collapsed. Rating agencies have begun to lower credit ratings on some states. The best guess is that ratings will drop on many other states before the year is over.

And, what about local and municipal governments? Same problems.

And, then, what about the federal government? Without totaling up the bill for the problems mentioned above, let alone the escalation of wars here and there all over the world, health care reform, and some kind of energy bill, many expect federal deficits over the next ten years to total $15 to $18 trillion!

Who is going to purchase all or almost all of this debt? China?

What I find scary is that our “friends” are voicing concern in different ways. For example, the Financial Times this morning carries the opinion piece of Gideon Rachman titled “Bankruptcy Could Be Good for America”: http://www.ft.com/cms/s/0/a8486284-fee9-11de-a677-00144feab49a.html. The point Rachman makes is that the Brics, Brazil, Russia, India, and China all went through economic reform before they “broke out” into their current ascendency. Brazil’s reform came in the 1990s, Russia defaulted in the late 1990s, India embraced economic reform in 1991, and China moved to a new mindset in the early 1990s. “Those much discussed emerging powers, the Brics, all needed a fiscal crisis to set them on the road to economic reform and national resurgence. America may one day be lucky enough to experience its very own national fiscal crisis.”

Even if we print money to pay for the federal debt, as the Federal Reserve has done over the last year or so, (the monetary base rose 23% from December 2008 to December 2009, and rose by 101% over the previous 12 months) someone, somewhere will pay this debt in terms of a reduction in purchasing power.

Need I mention that since January 1961 the purchasing power of one dollar has dropped to roughly $0.15. Inflating the United States government out of its debts has a long, post-World War II history.

Might this process of “printing money” continue?

Seems like a lot of people believe that it will. For one there is the problem of rising long term interest rates. More and more worry is being expressed about the expected increases. Why? Well most analysts believe that the Federal Reserve has helped to keep long term interest rates lower than they would have been in order to provide liquidity to the financial markets and to support the mortgage market. On January 6, 2010, the Fed held on their balance sheet $777 billion in U. S. Treasury securities, $160 billion in Federal Agency debt securities, and $909 billion in Mortgage-backed securities.

This totals $1.846 trillion in securities held by the central bank! The concern is that in the last week of August, 2008, the Fed had provided only $741 billion in funds to the banking system through some kind of market or auction based transaction.

How much affect these purchases have had on keeping long term interest rates lower than they would have been is currently being debated. What is not in question is that, sooner or later, interest rates are going to begin to rise, first because the Fed’s artificial support will be removed, but rates will rise as the economy begins to improve, further pressure will be put on rates as issuers of bonds race to place debt before the rise takes place (See “Rate Rise Fears Spark Rush to Issue Bonds: http://www.ft.com/cms/s/0/6f46f226-fef2-11de-a677-00144feab49a.html), and as inflationary expectations are incorporated into bond yields.

How fast will the Fed allow interest rates to rise because rising interest rates will slow down economic recovery. Also, the Fed has created another problem by keeping short term interest rates so low. Not only have these low rates created arbitrage possibilities for domestic investment, borrow short term money in the 35 to 65 basis point range and invest in 10-year government bonds at 3.50% to 3.80% but also for the international carry trade. It is argued that the Fed cannot allow rates to go up too fast or big financial institutions and other investors will get trapped in losses that will not help the economic recovery.

The point of all this discussion is that any “exit” strategy that the Fed is planning to reduce the securities held on its balance sheet from current levels to even a level of $1.0 trillion, let alone the $741 billion mentioned above, is already in jeopardy. And, many are arguing that in the face of such overwhelming future deficits, the Fed will be forced to print even more money than it has over the last 17 months.

The problem with debt is that debt, once issued, really does not go away. Someone has to pay for it!

Federal Reserve Exit Watch: Part 5

Something new this week: the Fed started to see how the financial markets would accept its strategy for reducing the size of its security portfolio. At the close of business on Wednesday December 9, 2009 the Federal Reserve showed $180 million on its balance sheet under the line item “Reverse repurchase agreements”.

The Federal Reserve had warned us that it was going to start “testing” the use of reverse repos as the mechanism for reducing the size of its securities portfolio. It had also informed us that a “test period” would begin last week.

It has begun, albeit in a very small amount.

Reserve balances with Federal Reserve Banks changed by only an insignificant amount last week.

Reserve balances did rise over the past 4 weeks and the past 13 weeks. In the last 4-week period reserve balances rose by a little more than $60 billion, $52 billion coming from factors supplying reserves and a negative $10 billion from factors absorbing reserves.

The $52 billion increase in factors supplying reserves was centered on an $85 billion increase in securities held outright ($79 billion in Mortgage-backed securities and $6 billion Federal Agency securities) and a $36 billion reduction in two accounts associated with the insertion of funds into the banking system early in the financial crisis last year. The Term Auction Credit Facility (TAF) dropped by almost $24 billion in the last four weeks and Central Bank Liquidity Swaps fell by about $13 billion.

The rest of the items connected with the innovative market facilities that the Fed created during the time of financial distress changed very little.

So the “Special Facilities” continue to wind down and the Fed continues to substitute marketable securities in its portfolio for the funds that were injected into the banking system to stem the crisis.

In terms of factors absorbing reserves at this time, the general account of the U. S. Treasury Department, its operating account at the Fed (it pays its bills out of this account), dropped by about $8 billion and this added reserves to the banking system and was the primary factor in the additional $10 billion increase in Reserve Balances mentioned above. The Treasury writes checks, they get deposited in banks, and bank reserves increase.

Over the longer term, the last 13 weeks, the government accounts have played a big part in the injection of reserves into the banking system. There is an account titled “U. S. Treasury, Supplemental Financing Account” which has been around since October 2008 (and reached a maximum of about $560 billion in November 2008 (Connected with TARP?). This account declined by $185 billion over the last 13 weeks.

The U. S. Treasury general account rose by $51 billion during this time, apparently the funds from the supplemental account were transferred to the general account so that they could write checks on it. Consequently, the net of the two, $134 billion got into the banking system and ended up as a part of Reserve Balances with Federal Reserve Banks.

During this 13-week period, the Fed also supplied $100 billion in reserves to the banking system through open-market purchases. To do this the Federal Reserve added $281 billion to the securities that it bought outright. The purchases were across the board: $229 billion in Mortgage-backed securities; $33 billion Federal Agency securities; and $19 billion in Treasury securities.)

The run-off in the special accounts over the past 13 weeks is obvious. The Term Auction Credit Facility (TAF) declined by $126 billion and Central Bank Liquidity Swaps fell by $45 billion, a total of $171 billion.

Primary bank loans from the discount window also fell by $10 billion so, over the past 13-week, period the Fed supplied reserves by buying $281 billion in securities and this was offset by a decline in “crisis” accounts of $171 and $10 in bank borrowing so that $100 billion additional funds reached Bank Reserves.

Conclusions:

1. The Federal Reserve continues to let accounts connected with the financial crisis run off. This appears to be going along quite smoothly.
2. The Federal Reserve continues to substitute funds from open-market purchases to replace the funds that are running-off. This appears to be going along quite smoothly.
3. The Fed is now testing the mechanism, Reverse Repurchase Agreements, by which it means to reduce its portfolio of securities and drain excess reserves from the banking system. The first test went along quite smoothly.
4. The U. S. Treasury supplemental financing account is now just $15 billion and will probably not be a big factor in changing bank reserves in the future.
5. The Federal Reserve is going to be facing a lot of “operating factors” over the next month that may cloud up any other actions that the Fed may be taking. These “operating factors” relate to government deposits and the increased use of currency in circulation during the holiday season. These disruptions should end by the middle of January 2010.

Note: Excess Reserves in the banking system still are running above $1.1 trillion. There is little evidence yet that banks want to do anything with these reserves other than hold onto them: this, in spite of the efforts of the Obama administration to get banks lending, especially to small business.

Federal Reserve Exit Watch: Part 4

This is the fourth month that I have posted something about the performance of the Federal Reserve with respect to their exit strategy, the strategy it is following to remove the massive amount of reserves it put into the banking system in 2008 and beyond. On November 11, 2009, the Fed was supplying $2,176 billion in reserve funds to the banking system. (This is from the Federal Reserve release H.4.1, Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.)

This was down slightly from the $2,233 billion total on October 14, 2009, but up from the $2,055 billion on August 12, 2009.

Commercial banks had $1,041 billion in Reserve Balances at Federal Reserve Banks on November 11 and the banking system averaged $1,059 in Excess Reserves for the two week period ending November 4, 2009. On October 14, Reserve Balances were $1,049 billion, but on August 12 this number was only $772 billion. Excess Reserves in the banking system averaged $918 billion in the two weeks ending October 7, and averaged $766 in the month of August.

Thus over the last 13-week period and over the past 4-week period total assets remained form around $2.1 trillion and $2.2 trillion.

However, Total Reserves in the banking system rose from $829 billion in August to $981 in the two week period ending October 7, to $1,124 billion in the two week period ending November 4.

This is an increase of over 35% in the total reserves of the banking system!

Of this $295 billion increase in total reserves, a total of $293 billion went into excess reserves!

Just a side note, Required Reserves rose by only $2 billion over the same time period!

No lending going on here!

The composition of the Fed’s balance sheet is changing, however. Securities held outright by the Federal Reserve has risen from $1,556 on August 12, 2009 to $1,673 billion on October 14 and $1,702 on November 11.

As reported in early editions of the Exit Watch, the Fed is letting the special assets it created run off as the need for them retreats and is replacing these reserves by marketable securities. Not all of these will run off in the near term as the credit and value issues surrounding assets at AIG and other institutions may take some time to disappear. However, these special assets have declined from somewhere in the neighborhood of $550-$500 billion on August 12, to $420-$380 on October 14 to around $340-$300 billion on November 11.

The largest decrease came from the reduction in the use of the Term Auction Credit which was instituted in December 2007 as a part of the dislocations in the financial markets that surrounded the problems at Bear Stearns. On August 12, this facility totaled $233 billion. The total dropped to $155 billion on October 14 and $109 billion on November 11.

Thus, the Fed is reducing the special assets portion of its balance sheet and is substituting for these asset, ownership of securities--Treasuries, Federal Agency issues, and Mortgage Backed securities.

In pursuing this path, the Fed is taking securities out of the open market, from banks and other financial institutions, but the funds it is using to pay for these securities is just going, so to speak, into bank vaults.

Commercial banks are basically saying, “If we don’t make any loans with this money, then the loans we don’t make cannot turn into bad loans!”

Another way of saying this is that the banks have enough bad assets on their books now and they don’t need to add any more. They’ll sell securities, but they won’t do anything with the money they receive back from the sale.

This seems to be creating a very uncomfortable situation. As the Fed reduced special facility assets over the last 13-week period and increased its holdings of open-market securities, it forced $300 billion reserves on the banking system.

Note that in August 2008, Total Reserves in the banking system amounted to $45 billion.

In 13 weeks the Fed forced 6.67 times more reserves into the banking system than the banking system had accumulated in all its history in the United States! And the banks did nothing with the reserves! And, the recession ended in the third quarter!

This is not a liquidity problem!

And the Federal Reserve says that it will continue to keep its target interest rates at its current level for an extended period of time. This is “QUANTATIVE EASING”!

Interest rates are going to start rising at some time. What is the Fed going to do with all the open-market securities it has on its balance sheet? What kinds of losses will the Fed have to take to eventually reduce reserves to reasonable levels once the economy begins to pick up steam?

Well, we really don’t need to worry about the Fed because the can just print money at a cost of zero in order to cover any losses they take.

But, what about those investors, what about the Chinese, what about anyone, who purchased United States Treasury securities during this summer and fall? How are they going to cover their losses when interest rates finally begin to rise?

The Federal Reserve got us here. There is no painless way to get us out of the situation they put us in…at least as far as I can see.

Thanks, Ben!

Building an Exit Strategy at the Federal Reserve--Part Two

Yesterday, I discussed what I saw as the reasoning behind the strategy the Federal Reserve is building to reduce the massive amount of excess reserves that it has injected into the banking system. The basic strategy seemed to be logical and reasonable and consistent with the way that economists usually think. That is, the arguments of economists always contain the assumption: “all other things held constant.” In other words, this is the plan, given that nothing else changes.

In the proposed strategy the Federal Reserve is developing, what is missing that might be crucial to the success of this strategy?

How about the fiscal deficits that the government is in the process of producing?

The deficit for the fiscal year ending this fall recorded the largest deficit in United States history: $1.4 trillion. And, some projections for the next ten years place the cumulative federal deficits around $15 trillion, more or less.

The Gross Federal Debt rose by 11.6% in fiscal 2008 and the estimates published by the government for fiscal 2009 and fiscal 2010 are 22.3% and 15.4%, respectively. The federal debt held by the public rose 15.2% in fiscal 2008 and is projected to increase by 35.4% and 21.9% in the following two years.

A lot of debt is going to be created by our government in the upcoming future and the assumption is that the public is going to absorb greater increases in the amount of debt they hold than ever before in peacetime!

The increases in debt over the past seven years have been of epic proportions. Carmen Reinhart and Kenneth Rogoff, in their informative new book “This Time is Different”, state of this buildup: “Were the United States an emerging market, its exchange rate would have plummeted and its interest rates soared. Access to capital markets would be lost…” They continue, “Over the longer run, the U. S. exchange rate and interest rates could well revert to form, especially if policies are not made to re-establish a firm base for long-term fiscal sustainability.”

Why do the exchange rates of nations that exhibit such fiscal irresponsibility decline?

The answer to this is that, sooner or later, the central banks of these nations have to become active in supporting the placement of the debt and this results in the monetization of that debt.

The question then arises, “Can the Federal Reserve reduce the amount of excess reserves it has injected into the banking system given the market pressures that surround the problem of the placing of the federal debt that is going to be created?”

Let’s look what seems to happening right now.

Some have argued that the Federal Reserve’s policy of “buying everything in sight” has created an asset bubble. The result has been that the prices in many different asset classes now move together: the movements in these asset classes now possess a high positive correlation rather than a zero or negative correlation. Thus, investors can achieve very little diversification across markets. And, as a consequence, the market volatility indexes have risen to remarkable highs.

The extremely low target interest rates, the quantitative easing, and the massive flows of capital into the United States resulting from the accumulation of foreign exchange reserves by foreign central banks keep Treasury bond prices high, prices of mortgage-backed securities high, United States equity prices high, and global asset prices high. (A bubble you say?)

To support the bond market and the market for mortgage-backed securities, that is, to keep interest rates low, the Fed has continued to pump reserves into the banking system. The reserve balances that commercial banks hold at Federal Reserve banks jumped $236 billion from September 30 to October 28 so that they totaled $1.080 trillion on this latter date. Excess Reserves held by commercial banks rose by around $190 billion from the end of August to the end of September, to around $1.0 trillion.

If these security prices are artificially high (and interest rates artificially low) due to Federal Reserve support, what will happen when the economy picks up activity and the Fed has to back off its underwriting of low interest rates? What will happen if this “backing off” coincides with the need of the Federal Reserve to “exit” from its excessively loose policy?

As I wrote earlier, the proposed exit strategy that the Federal Reserve is exposing to the public seems “logical and reasonable” given that “all other things are held constant.” Unfortunately, policy makers do not work in a world in which “all other things are held constant.”

Again, the policymakers are faced with the problem of dealing with the aftermath of earlier policy actions. As I have argued, the irresponsible fiscal policy of the early 2000s and the excessively low interest rates maintained by the Federal Reserve during this time (supported by both Greenspan and Bernanke) created the environment for the financial collapse of 2007-2008. The Bernanke Federal Reserve faced this collapse, to accumulating accolades, by throwing everything it could against the wall to see what would stick. (The lesson Bernanke learned from his research on the First Great Contraction was that in order to avoid a great contraction one had to leave nothing on the table for if one is going to err one must err on the side of excessive ease.)

Now we are faced with the problem of dealing once again with the left-over’s of previous fiscal and monetary policy. We are once again faced with a situation in which there are no “good” policies that are painless. As Reinhart and Rogoff conclude from their massive study of “Eight Centuries of Financial Folly”, pain cannot be avoided once financial folly has been committed.

Let me close once again as I closed my post yesterday: the Fed is in a delicate position. They cannot get out of this situation by “throwing everything it can against the wall.” Let’s just hope that they can find a way to get out of their conundrum with the least amount of negative consequences.

Building the Exit Strategy at the Federal Reserve

Interest continues to grow about how the Federal Reserve is going to remove all of the reserves that it has injected into the banking system. The articles are getting personal now. See, for example, the article in the Wall Street Journal this morning that actually brings us a name, Brian Sack, who is the head of the markets group at the Federal Reserve Bank of New York and the person responsible for developing the “exit strategy” that the Fed will use to remove the $1.0 trillion, more or less, excess reserves that reside on the balance sheets of the country’s commercial banks. (“Brian Sack Engineers Big Moves at Fed,” http://online.wsj.com/article/SB125720947716624249.html#mod=todays_us_money_and_investing.)
The basic problem facing the Federal Reserve is that the Fed has pushed an enormous amount of funds into the banking system and, at some time, is going to have to remove those reserves so as to avoid the possibility of stimulating a massive amount of inflation in the United States. Thus, the Fed needs to go back to where it was once, or, at least, somewhere around there.

The first question that arises is exactly what date do we go back to? Do we go back to the week before the week of September 15, 2008 when the financial collapse became paramount? Or, do we go back to the middle of December 2007 when the Bear Sterns deal was cut? Around this latter date we get the creation of the Term Auction Facility (TAF) that was a first innovation of the Fed to meet the financial crisis that was in its early stages. Let’s use both dates to see if there is any substantial difference between the two.

I have made three, rough calculations about the “excess” funds that the Fed needs to remove from the banking system if we are to get back to a Fed balance sheet that looks something like either the ones that existed on either December 19, 2007 or the September 10, 2008. I use the actual Wednesday data and not the averages of daily figures for the banking week ending on those dates.

The three rough numbers are $1.3 trillion to get back to the balance sheet of the earlier date and $1.1 trillion to get back to 2008 date. My third estimate is generated by assuming that the Federal Reserve balance sheet would grow from December 19, 2007, at a (generous) 10% annual rate up to the current reported figure for October 28, 2009. This third figure is $1.1 trillion. All these numbers are rounded off so as to produce general targets so that we have a rough idea of the magnitude of the task.

So, given these estimate the Federal Reserve needs to remove approximately $1.1 to $1.3 trillion from its balance sheet.

Now, there are two parts to the removal of these funds from the balance sheet. The first has to do with very specific responses to the crisis, either in terms of particular markets or in terms of particular institutions. In terms of particular institutions, I am referring to the “line items” on the balance sheet that relate to the Bear Sterns and the AIG deals. In terms of particular markets, I am referring to the facilities set up for Primary Dealers and Broker-Dealers, Commercial Paper Funding, Money Market liquidity funding, Central Bank liquidity swaps and so forth.

The current strategy of the Federal Reserve with respect to these specific “line items” is to let the dollar amounts decline at their own speed as the need for them dissipates or as the assets are worked off. This strategy is already reflected in the balance sheet results examined in my series on the Federal Reserve Exit Watch: see http://seekingalpha.com/article/167300-federal-reserve-exit-watch-part-3, and, http://seekingalpha.com/article/162274-federal-reserve-exit-watch-part-2.

The total of these accounts, as of October 28, 2009, is $412 billion. These accounts seem to be declining on a regular basis and there is really little or nothing that the Fed can do to speed this decline along. In fact, you want these accounts to be reduced at their own pace because as the need for the assistance goes away, the accounts will fall to zero. True, some of the accounts could remain on the books for an extended period of time, but these will be minor relative to the whole balance sheet.

If you remove these numbers from the shrinkage that needs to take place on the Federal Reserve balance sheet you are left with numbers in the $700 to $900 billion range. The total of Mortgage-Backed securities on the balance sheet as of October 28, 2009 is $774 billion. Federal Agency securities totaled $142 billion on that date. Thus, the “active” strategy for reducing the Fed’s balance sheet relates to these specific security portfolios.

This is where the proposed program called “reverse repos” comes into the picture. Obviously, the Fed cannot just dump $774 billion in mortgage-backed securities on the financial markets. (There is even some concern that Congress may want the Federal Reserve to hold onto a large portion of these securities so as to continue to support housing in the United States. That, however, raises other issues.)

Furthermore, the Federal Reserve is very cognizant of the events of 1937. The United States economy had recovered from the Great Depression (or Great Contraction) and was experiencing relatively satisfactory growth at that time. The commercial banking system, however, was holding onto a large amount of excess reserves (not unlike the current situation). In order to tighter their control over credit, the Federal Reserve, in all its wisdom, raised reserve requirements.

The result was disastrous! The bankers wanted those excess reserves and the removal of them caused the banking system to contract even more and the amount of credit and money in the economy contracted as well. The 1937-1938 depression was the result.

The Federal Reserve does not want to duplicate such a mistake. Consequently, they are going to try and “ease” the funds out, not “yank” them out. This, seemingly, is the reason why the Fed is looking at the “reverse repos’ program as an alternative. Because “reverse repos” would represent the “temporary” removal of funds from the banking system and because they would be undertaken through market transactions, the Fed would not get “ahead of the curve” in removing reserves from the banks. That way, they would constantly be “in the market” and be able to determine if there was any resistance to the removal of funds. In that way, they could proceed incrementally toward selling the securities and then, as the markets allowed, actually sell them outright from their securities portfolio.

The Federal Reserve is in a delicate position. They know that they will need, at some time, to remove the excess reserves from the banking system. However, they don’t want to move too fast and create another financial crisis, as happened in 1937. But, the Fed knows that at some time it is going to have to remove the excess reserves as quickly as it can.

Let me repeat, the Federal Reserve is in a delicate position! In talking about “exit strategies” in the public domain, Fed officials hope to keep the financial community informed and prepared for what might be done and at the pace it at which it will be done.

Federal Reserve Exit Watch Part 3

This is the third post in a series designed to review the progress of the Federal Reserve in its efforts to exit the position it has created for itself by more than doubling the size of its balance sheet. (The first two posts in this series appeared on August 21 and September 18.) Some fear that if the Fed cannot reduce the size of its balance sheet that the amount of reserves that have been put into the banking system will explode in the creation of new credit which will be followed by an explosion in the various measures of the money stock. This can only be inflationary with substantial concern that such inflation could turn into hyperinflation.

The fear of many others is that the Fed will withdraw these funds too quickly thereby causing the banking industry further problems and the experience of a second financial collapse.

Bottom line: Reserve Balances with Federal Reserve Banks rose by $190 billion in the four weeks ending October 14, 2009. The rise over the last thirteen-week period was $244 billion. These Reserve Balances totaled $1,049 billion on October 14, a new record high! These data are taken from the Federal Reserve Statistical Release H.4.1.

Required reserves in the banking system averaged about $63 billion in the two banking weeks ending October 7. Excess reserves in the banking system, as reported in the Federal Reserve Statistical Release H.3 were $918 billion for the same period of time. Reserve Balances with Federal Reserve Banks were $963 billion on October 7.

Obviously, there are plenty of reserves in the banking system and the banks still do not seem to be in any mood to begin lending again. See my post on the lending activity in the banking system to support this conclusion: http://seekingalpha.com/article/165994-commercial-real-estate-lending-problems-hitting-the-smaller-banks.

Where did this $190 billion of new reserve balances come from?

Well, about $52 billion came from factors supplying reserves to the banking system and another $137 billion came from a reduction in factors that were absorbing reserve funds. For the thirteen week period, factors supplying reserves contributed $121 billion to the $244 billion increase and there was a $123 reduction in factors absorbing reserves. Let’s look at both in turn.

As was highlighted in the previous two reports on the exit strategy of the Fed, the monetary authorities continued to allow accounts associated with the special facilities created to deal with the financial crisis to run off. These reductions were offset by purchases of financial assets. This seems to be the first move strategy of the Fed to achieve its exit from the big buildup.

Over the past four weeks, there was a $61 billion decline in three asset categories connected with the new facilities that were created. The Term Auction Facility (TAF) declined by almost $41 billion, the portfolio holdings of Commercial Paper declined by $3 billion and the line item associated with Central Bank Liquidity Swaps fell by a little more than $17 billion.

Over the last thirteen weeks these three items declined by almost $260 billion: TAF dropped by $118 billion; the commercial paper facility by $71 billion; Central Bank swaps fell by $68 billion.

The Fed replaced these run-offs by open market purchases that more than covered the outflow, hence the overall increase in bank reserves. For example, Securities Held Outright by the Fed jumped $103 billion in the last four weeks and by over $360 billion in the last thirteen weeks.

The Fed is therefore allowing the special facilities to decline where possible and is then maintaining the liquidity of the banking system by purchasing securities in the Open Market!

In purchasing securities in the open market the Fed is buffing up the liquidity in these markets and helping to keep interest rates low. Of particular note, the Fed has added $78 billion in Mortgage-Backed Securities to its portfolio over the last four weeks and $237 billion over the last thirteen. The Fed has purchased Federal Agency Securities in recent weeks: this portfolio has increased by $11 billion and $35 billion in the last four and thirteen weeks, respectively.

Two other items of note: first, something called Other Federal Reserve Assets rose by $6 billion over the last four weeks and by $13 billion over the last thirteen weeks. What is in this account? Well, the Federal Reserve states that this account includes Federal Reserve assets and non-float-related “as-of” adjustments. These may include Assets Denominated in Foreign Currencies or Premiums Paid on Securities Bought. We don’t really have any information on the totals, but these amounts are relatively substantial amounts, especially when the required reserves in the banking system only total $63 billion.

The second item that requires some attention is that the Special Drawing Rights (SDR) account at the Fed increased by $3 billion over the last four weeks. Actually the increase came in the banking weeks ending September 23 and September 30. Thus the Special Drawing Rights certificate account at the Federal Reserve rose from $2.2 billion to $5.2 billion during this period. I am going to have to do more research into this increase and what it means.
In the meantime here is a definition of the SDR: SDRs were originally created to replace Gold and Silver in large international transactions. Being that under a strict (international) gold standard the quantity of gold worldwide is finite, and the economies of all participating IMF members as an aggregate are growing, a purported need arose to increase the supply of the basic unit or standard proportionately. Thus SDRs, or "paper gold", are credits that nations with balance of trade surpluses can 'draw' upon nations with balance of trade deficits. So-called "paper gold" is little more than an accounting transaction within a ledger of accounts, which eliminates the logistical and security problems of shipping gold back and forth across borders to settle national accounts.

The other major contributor to the rise in reserve balances at commercial banks was a movement out of federal government accounts at the Federal Reserve. There was a movement of $157 billion out of government accounts in the last four weeks and $149 billion in the last thirteen. A reduction in these accounts takes place when the government disburses money and the funds end up as bank reserves. In terms of the governments’ general account, the movement of funds, in and out of this account, is usually connected with seasonal tax collections and disbursements.

There is another account that saw a large reduction, $100 billion, over the last four weeks. This was in an account called the U. S. Treasury Supplementary Financing Account. The Fed defines this account in this way: “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, a movement out of the Fed injects deposits into depository institutions.” We need more information on this decline.

To conclude: The Fed continues to reduce dollars associated with the new facilities created to combat the financial crises. It is replacing these dollars with open market purchases that keep the banking system liquid. Other transactions have also taken place related to federal government disbursements that add reserves to the banking system. In restructuring its balance sheet the Fed is being sure to err on the side of being too loose in supplying bank reserves. Obviously, the leadership at the Fed does not feel that any type of constraint should be imposed upon the banking system at this time.

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!