Federal Reserve Watch: Reserve Balances Down another $70 Billion

Reserve balances with Federal Reserve Banks were down $69.6 billion this past week. Last week, reserve balances were down by $122 billion.

Reserve balances with Federal Reserve Banks is a line item on the Federal Reserve’s balance sheet, available through the H.4.1 statistical release, “Factors Affecting Reserve Balances of Depositary Institutions and Condition Statement of Federal Reserve Banks.”

Since March 16, 2022, the week that the Fed really began its tightening program, reserve balances were down by $914 billion.

Reserve balances with Federal Reserve Banks are deposits that commercial banks have at commercial banks and can be used as a rough proxy for “excess reserves” in the banking system.

Since March 16, 2022, the Federal Reserve has been tightening up by reducing these reserve balances while at the same time pushing up the Fed’s policy rate of interest.

On March 16, the effective Federal Funds rate was 0.08 percent. The Fed then made the move to raise the effective Federal Funds rate by 25 basis points, to 0.33 percent.

On December 14, 2022, the Federal Reserve made the move to bring the effective Federal Funds rate up to 4.33 percent.

All along the way, the Fed has reduced the reserve balances in order to “tighten up” on the banking system and support the higher and higher policy rate of interest.

Securities Portfolio

The major part of the Fed’s effort to tighten up on monetary policy is the attempt to reduce the size of the Fed’s securities portfolio.

During the years 2020-2021, the Federal Reserve worked to protect the banking system and the economy from the effects coming from the spread of the Covid-19 pandemic and following recession.

The Federal Reserve added more than $4.5 trillion in securities purchased outright to its portfolio during this time period.

Reserve Balances with Federal Reserve Banks rose to almost $8.5 trillion by April 20, 2022.

Jerome Powell, Chairman of the Board of Governors of the Federal Reserve System, and other members of the Board strongly believe that the portfolio needs to be reduced substantially to get monetary affairs back to a “more normal” level.

So, a major part of the Fed’s effort to fight inflation is attached to this effort to reduce the size of the Fed’s portfolio of securities bought outright.

So far, however, the Fed has only been able to reduce the securities portfolio by about $350 billion.

There are a lot of things going on within the banking system, and the Federal Reserve must manage its balance sheet so as to keep the financial system as stable as possible, given the efforts to substantially reduce the size of the Fed’s securities portfolio.

Since March 16, 2022, the Federal Reserve has seen the deposits of the Federal Government go down quite a bit, by more than $250 billion.

To offset this, the Fed has engaged in an additional $700 billion of reverse repurchase agreements in order to maintain the stability of the short-term money markets.

Furthermore, the private sector has withdrawn more than $35 billion in cash from the banking system, reducing the reserves in the banking system.

So, the Fed has to manage all these inflows and outflows in order to “balance” the supply and demand for funds in the money markets.

So, the Fed has been able to reduce its securities portfolio by almost $350 billion, but has also had to manage the rest of its balance sheet as well as it can to maintain the Fed’s target rate of interest.

This is not an easy job.

The Money Stock

The impact of these Federal Reserve actions have had a major impact of money stock growth.

Note that from December 2019 through December 2020, the M2 measure of the money stock rose by just under 25 percent.

From December 2020 through December 2021, the M2 measure of the money stock rose by a little more than 12 percent.

Since the Fed began to “tighten up” its monetary policy, from November 2021 through November 2022, the M2 money stock has only grown by 1.1 percent.

The growth rate of the M2 money stock is expected to go negative in the early parts of 2023.

So, in terms of macro-variables, the Federal Reserve seems to be having the effect it wants in order to substantially slow down the rate of inflation.

The Stock Market

The investment community still seems to believe that Mr. Powell and the Federal Reserve will not stick with its monetary tightening for too much longer.

Stock prices remain very volatile as investor continue to believe that a Fed pivot is not too far in the future.

2023

What can be expected of the Fed in the coming year?

It’s going to be the battle against an inflation rate that is too high and a stock market that is on the edge of collapse.

In other words, when is the Fed going to back off.

The Fed has plans to continue its “quantitative tightening” into 2024.

The Fed purchased a lot of securities over the past two- to three-years.

A lot of this liquidity has to be swept up. But, as we have seen, some of the beneficiaries of Fed’s earlier largesse are now paying the price.

The cryptocurrency space is one such area.

The SPAC-space is another such area.

The Fed’s staying power is going to be dependent upon things “staying together” long enough so that the Fed’s securities portfolio can be reduced significantly.

It is going to be a period of radical uncertainty, because we don’t know what all the possible outcomes are. And, the Federal Reserve officials don’t know any better than we do.

Right now, the Fed is sticking to its guns. Let’s hope the Fed is able to continue this position into 2023 for as long as it can.