Getting Back to Business at the Fed

The Federal Reserve, of course, garnered a lot of press headlines today because of the announcement made yesterday that it is raising the discount rate on primary credit from 50 basis points to 75 basis points. This action will become effective today.

Note that this change came at the request of the boards of directors of the 12 Federal Reserve Banks who petition the Board of Governors for a change in this discount rate. Technically, at least, the borrowers of primary credit from the Federal Reserve System still borrow from each district bank which has its own discount rate. Thus, for a district bank to change the rate it charges on loans at its discount window, it must petition the Board of Governors. This is the archaic structure still present in the rules of the Federal Reserve for the conduct of business at the discount window in each district bank.

In addition, the Fed reduced the “typical maximum maturity f,or primary credit loans” to overnight. Earlier, as announced on November 17, 2009 and implemented on January 14, 2010, the Fed had moved to “normalize” the terms on primary credit by reducing the typical maximum maturity to 28 days.

The Fed in trying to get back to business as it was before the financial crisis. This is a part of the Fed’s “undoing.” See my Federal Reserve Exit Watch, http://seekingalpha.com/article/187265-federal-reserve-exit-watch-part-7, and my Fed “undoing” post, http://seekingalpha.com/article/187292-tightening-at-the-fed-get-ready-for-the-undoing.

The basic function of the discount window in normal times is to serve as an “escape valve” for commercial banks that need “temporary” funds to cover an unexpected need. The discount rate usually costs more than other sources of funds and borrowing is discouraged by the amount of time a bank can borrow from the Fed. But, that is the whole purpose of the “window”: it is a “last resort” for banks to relieve short run pressures on their balance sheets.

In times of crisis, the discount window is, in a sense, “thrown open” to provide liquidity to the market and overcome short term liquidity crises. A classic example of such a situation was the August 1987 liquidity crisis faced by a newly appointed Fed Chairman Alan Greenspan.

Of course, the 2007-2009 financial crises required something more and the opening of the discount window was on much more liberal terms in order to prevent the crisis from worsening.

Now, “The increase in the spread and reduction in maximum maturity will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve’s primary credit facility only as a backup source of funds.”

The Fed is trying to get back to “business as usual”. As described in the two posts mentioned above, the Fed seems to be separating its balance sheet into two parts: a balance sheet of a “traditional” central bank and a balance sheet composed of the short-term tools that were used to meet the special needs of commercial banks and the financial markets during the time of crisis.

So, these changes “are intended as a further normalization of the Federal Reserve’s lending facilities.” They are just an integral part of the Fed’s “undoing.”

In terms of the special tools, one part of the Fed’s crisis response was the implementation of the Term Auction Facility (TAF) on December 12, 2007. The Fed announced yesterday that the final TAF auction will be on March 8, 2010. This facility played an especially important role in providing liquidity to commercial banks during the financial crisis. It was seen as getting reserves to the banks that needed them more quickly than “normal” open market operations could. Furthermore, the funds were provided on a “term” basis. The Fed began to reduce the size of the auctions on June 25, 2009 and has continued to allow this line item to phase out as the year progressed. This “phasing out” is occurring with respect to other “special tools” as well.

We will continue to see more of these adjustments as the spring and summer of 2010 pass by. Market participants should not be “shocked” by these changes. They are a part of the attempt to return to a “more normal” basis for operations.

In my mind, eyes need to be focused more on what the Federal Reserve does with its securities portfolio, whether or not it is engaging in reverse repurchase agreements, and what it does to the pricing of the excess reserves the banks have on deposit at the Federal Reserve banks.

My guess is that movements will be made in these items before we see changes taking place in target interest rates. Acting in this way is more consistent with the past operations where the Fed has encouraged market conditions to change and then moved rates in line with the changes that already exist within the market. Historically, the Fed has preferred incremental moves to “market shocks”.

With market sensitivities being so “on edge” and so potentially volatile and with the “undoing” being such a massive job, the Fed cannot afford to have market emotions swing to extremes all the time. This would only make the Fed’s job that much harder.

Expect the Federal Reserve to be more subtle than that. The leaders at the Fed have a monumental task in front of them. I am sure that they hope that their “undoing” will not prove to be the undoing of all that has been accomplished up to this point in time.

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 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.