Federal Reserve Exit Strategy: Part 10

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Discussion About Taxes

The real discussion on taxes, hopefully, has begun. The New York Times, in it’s lead editorial of Thursday, April 24, 2008, headlined the “Empty Talk on Taxes” presented a case for raising taxes. It began by saying—

“One of the toughest questions that will face the next president is what to do about taxes. There can be no real progress on health care, rebuilding the military or any other major issue without dealing with rising budget deficits and mounting debt…”

And, it ended—

“Perhaps the candidates are afraid the American people can’t handle the truth about what it would take to meet the nation’s economic challenges. Or perhaps they are underestimating those challenges.”

For the complete editorial, see http://www.nytimes.com/2008/04/24/opinion/24thu1.html?_r=1&scp=1&sq=empty+talk+on+taxes&st=nyt&oref=slogin.


I have been arguing for quite some time now that the number one issue that will be facing any new administration will be the decline in the value of the United States dollar. There is only one way to halt the decline in the value of the dollar, let alone strengthen it, and that is to substantially reduce the government’s budget deficit and follow a monetary policy that is focused (almost) solely on constraining inflation. The problem is the timing.

The current focus of America is on the recession and the financial instability that now exists within U. S.-based, as well as internationally-based, financial institutions. And, with new reports coming out almost daily about weak economic conditions or another bank being in desperate need of raising additional capital, the focus of the press will not be taken off the current economic conditions within the United States. To begin any discussion about the economic and financial policies that are necessary for strengthening the dollar will be difficult, at best.

The “economic challenges”, to quote the NY Times, are going to be substantial and to talk of this “truth” is difficult if one is trying to get elected. Also, the best guess is that the “challenges” are being underestimated because those connected with the candidates are trying to get nominated and then elected. These “challenges”, whatever they are can be dealt with later.

But, the problems are not going to go away. Whereas the inflation that took place in asset prices has burst, the inflation in commodity prices continues on apace. And, as long as this takes place the value of the dollar will continue to decline. My best guess is that, in terms of family, business, or investment decisions, individuals must be prepared for a lengthy period of time in which uncertainty will be substantial and volatility in markets will be commonplace.

The reason why I believe this will be the case is that the United States is the only major country in the world that is not playing by the rules of the international monetary system. (I discussed this on my April 14 post.) Other nations have given up a lot in order to bring themselves into line with these rules and have suffered further because they have stuck with the rules while the Bush administration has not. This is why the United States is not getting a lot of cooperative movement on the part of other central banks to help it bail itself out. Eventually, it, the United States, will have to join the international financial community and go through the necessary pain to get itself on the right path.

I believe that this fact need to be considered in every decision to be made concerning the family, business, or investment interests of Americans over the next two to three years.

Aside: Robert Barro, Professor of Economics at Harvard, in the latest edition of his book “Macroeconomics” (pages 359-360), discusses how a presidential administration might “strategically” manage the federal budget so as to have a large impact on the budget decisions of the administration that follows it. Basically, he writes, the incumbent administration can create such large budget deficits that the following administration will be severely limited in what it can do because it must deal with the deficits that it has inherited. Barro specifically mentions the Reagan (and Bush 41) administration creating a situation in which the Clinton administration was limited in what it could do, once it attained office. To quote Barro:

“Arguably, this is what happened in the 1990s. In this sense, the Reagan-Bush strategic budget deficits may have worked.” (page 360)

Is this what Bush 43 has done?

Is the budget mess, the dislocation of the economy, the inflating commodity prices, and the declining value of the dollar…all to keep the following Democratic administration from initiating policies that the Bush administration does not want to see enacted?

You decide!