Federal Reserve Watch: How Long

The Federal Reserve is really showing its discipline in the current program of quantitative tightening it is following to battle the inflation presence.

The Federal Reserve set out in March 2022 to shrink its securities portfolio.

So, the tightening has been in place for almost one year now.

Here is what the Fed’s securities portfolio looks like.

On Wednesday, March 16, 2022, the Fed held, outright, $8,490.5 billion in securities.

On Wednesday, February 15, 2023, the securities portfolio totaled only $7,990.5 billion.

The decline…$569.0 billion.

And, the chart shows just has consistent the Federal Reserve has been in reducing the size of its portfolio.

The plan is for the Federal Reserve to continue this reduction in the securities portfolio into 2024.

The Effective Federal Funds Rate

The reduction in the securities portfolio has gotten very little attention in the press.

However, it is the real foundation of the policy effort the Fed is pursuing.

What has gotten the attention of “the Press” has been the Fed’s change in its policy rate of interest…the Federal Funds rate.

Here is the picture of what the Fed has done in this area.

Here we see a nice steady progression of interest rate increases, bringing the current rate up to 4.58 percent.

Looks like a nice pattern that is roughly the inverse of the movement in the Fed’s securities holdings.

However, it has not been such an easy trip for the Federal Funds rate.

Certainly, the movement in the Fed’s securities portfolio has been important, but an even more important factor has been the Fed’s management of the “excess reserves” in the commercial banking system.

In checking out the excess reserves in the commercial banking system, I am going to divide up the time period into two sections. First, there is the initial period of Federal Reserve tightening. Second, there is the rest of the tightening period.

Here is the chart going from January 5, 2022 until August 31, 2022.

This is the period when the drop in Reserve Balances with Federal Reserve Banks dropped the most.

The movement in these reserve balances was kind of erratic, with some major weekly changes taking place.

This behavior shows, to me, the effort Federal Reserve officials made in order to support the increases in the effective Federal Funds rate. Of course, there were movements of funds into and out of the General Account and other accounts used by the U.S. Treasury Department. Then there were also, at times, major movements in the account for reverse repurchase agreements.

So, the Fed was engaged with other operations that impacted the financial markets that supported the increases that were being made in the effective Federal Funds rates.

The increase in the Federal Funds rate could not be as smooth as it was without these other actions surrounding the reduction in the size of the Fed’s securities portfolio.

The second time period.

Note that “Reserve Balances” were relatively flat during this second time period.

Still, the Federal Reserve was able to manage to continue the upward movement in the effective Federal Funds Rate, even while the securities portfolio was still declining in a very steady manner.

Obviously, Federal Reserve officials had to “manage” the excess reserves in the commercial banking system.

The Federal Funds rate did not “smoothly” rise during this period of time, solely at the reduction of the Fed’s securities portfolio.

The question can be raised about the use of the line item “Reserve Balances with Commercial Banks” as a proxy for “excess reserves” in the banking system.

To check this out, one can go to the H.8 Federal Reserve statistical release and follow the movement of “cash assets” held by commercial banks.

Both in terms of the total amount of “excess reserves” on commercial bank balance sheets and the movement of “excess reserves” on bank balance sheets, the numbers are highly correlated.

As “Reserve Balances with Federal Reserve Banks” moved, so did the cash assets held by commercial banks. And, the “totals” were very much coordinated, somewhat over $3.0 trillion.

Federal Reserve Policy

Federal Reserve officials have made a very convincing story, as depicted in these charts, that they have a very specific goal in mind and that they are proceeding on the path to achieve this goal with a focused eye.

Therefore, the major question investors should be asking is, “how long does the Fed intend to carry on this policy?”

The market volatility, especially the volatility of stock market prices, should be attributed to just one factor…investors’ anticipation that the Fed will stop raising its policy rate of interest.

This is where all the fuss has been.

Federal Reserve officials, as can be seen from the chart above, have been very steady in their application of quantitative tightening.

It has only been investors’ “angst” that has caused stock prices to jump around so.

Federal Reserve officials initially indicated that this quantitative tightening would go on for quite some time.

Unless there is a market collapse, I think that they will achieve that initial goal.