This past week’s turmoil came from the emerging market countries, especially Argentina, where the rising value of the US dollar resulted in major market movements causing all sorts of disruptions.
The Federal Reserve remained calm and continued on its efforts to reduce the size of its balance sheet and shepherd US interest rates higher. Chairman Jerome Powell even provided words of confidence about the ability of these emerging market nations to weather the stormy waters in a speech he gave this week.
Overall, the Federal Reserve has done very well in reducing the size of its securities portfolio. Since September 27, 2017, the securities portfolio, counting adjustments for premiums and discounts on the balance sheet, has fallen by almost $107 billion.
The original plan put out by the Federal Reserve pointed to a reduction in the portfolio by $120 billion by the end of April 2018. Overall, reserve balances held by the banking system with Federal Reserve banks, a proxy for “excess reserves” in the banking system, have dropped by $132 billion. But this has all been done calmly and without any disruptions in the banks.
And, this has been done while financial markets in the United States have become more volatile over the past six months or so. Furthermore, with all of this activity going on, the Fed still has to deal with operational factors impacting the banking system along with the need for the Fed to reposition itself so that it can get back to more “normal” business practices.
As far as operational factors hitting the balance sheet, the Fed has had to accommodate an increase in currency in circulation of $69 billion since the current strategy has begun. This means that the banking system lost this amount of bank reserves over the past seven months. This drain on reserves has been successfully accommodated by the Fed.
But, I think that the Fed is going to have an interesting job in the near future repositioning its balance sheet so that it can be prepared for more short-run monetary management.
In this respect, the main thing the Federal Reserve will be facing in coming months in the continuation of its march to a smaller securities portfolio is how the Fed and the US Treasury Department manage the government’s General Account at the Federal Reserve.
When the Treasury moves funds to the Federal Reserve, this removes funds from the banking system. As funds flow the opposite way, funds are returned to commercial banks.
Since the end of quantitative easing, the Federal Reserve and the US Treasury have worked together to use the General Account as one of the tools that were used to manage reserve balances in place of Federal Reserve open market operations using the Fed’s securities portfolio.
This “tool” was used alongside the other major tools used at this time: reverse repurchase agreements and term deposits.
As the Federal Reserve began to reduce the size of its securities portfolio in the last quarter of 2017, it appears as if the Federal Reserve and the US Treasury Department continued to work together to use the General Account to assist in the overall effort to reconstruct the Fed’s balance sheet.
For one thing, as the Federal Reserve reduced the size of its securities portfolio, it wanted to reduce its use of reverse repurchase agreements to manage reserve balances. The Fed really relied on this tool during the past two-and-one-half years and it really stretched its abilities.
The plan has been to reduce the use of these as the securities portfolio is reduced so as to eventually free it up just for short-run reserve management…it’s more normal function.
Consequently, the part of the balance sheet that contained the outcomes of this “tool” has been reduced by $217 billion since the effort to reduce the securities began at the start of the fourth quarter of 2017. A reduction in reverse repurchase agreements puts reserves back into the banking system.
To offset this, it appears as if the General Account was increased during the same time period to put reserves back into the banking system so that the banking system would not experience any shortfalls of liquidity.
The Treasury’s General Account was at a near term peak of about $400 billion on May 2, 2018, up from around $157 billion on December 20, 2017. The rise in these balances took place at the same time that the decline in the use of reverse repurchase agreements fell.
But now the “other” line item in the reverse repurchase agreement category has been reduced to only $2.7 billion. Thus, this “tool” has been “freed” to return to its “more normal” purpose of managing short-run changes in bank reserve positions. This, I believe, is a good thing.
Now the level of the Treasury’s General Account must be reduced to “more normal” levels. What are “more normal” levels? Before the end of the third round of quantitative easing in late 2016, the amount of funds in the General Account basically remained below $100 billion.
This seems to be to be a workable number. I do not think, at least in the foreseeable future, that these balances will drop to the levels they were before the Great Recession. Then, the General Account ran in the $4-to-$6 billion range.
I believe that since the tax season is over that the Fed will try and reduce the size of the General Account. Doing this, however, will put more money back in the banking system. But if this takes place at the same time that the Fed is continuing to reduce the size of the securities portfolio, which takes money out of the banking system, then we have an offset.
Treasury accounts at commercial banks will rise while securities maturing off of the Fed’s balance sheet will need to be purchased, and this will reduce funds at commercial banks. So, bank reserves should not be disrupted in a major way.
And it seems to me that the Fed is starting to think this way. Furthermore, in order to help it accommodate the decline in the General Account, for the next week or so, the Fed is collecting funds, once again, through a call for term deposits at the Fed… which reduces bank reserves.
Just yesterday, the Fed put out an offer to commercial banks for seven-day term deposits. This appears to me to be an effort to draw in some funds to facilitate the reduction in deposits in the General Account of the Treasury. Again, the Fed wants things to move ahead as smoothly as possible so it is thinking ahead.
The Federal Reserve is managing the reduction in its securities portfolio with every intent of getting the size of the portfolio down to a “more normal” level. If the Fed stays close to its announced schedule, the securities portfolio should be $450 billion less at the end of this year than it was at the start of the third quarter in 2017.
And the Fed is planning to do this in as methodical a way as possible.
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