Federal Reserve Surveillance: The Coming Dilemma

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Well, based on the results of the last Fed banking week (the week ending February 9, 2022), it finally looks like a real cut is happening.

Last week, the Fed only added $3.8 billion to its securities portfolio.

That’s down from the $125.0 billion it added in the five weeks prior to last.

It should be noted that the Fed oversaw an increase in reserve balances with Federal Reserve banks, an indicator of excess bank reserves, of $38.4 billion.

The increase is the result of the federal government reducing its general account at the Fed by $31.3 billion.

The US Treasury General Account at the Fed is the main account to which the government issues checks.

This is the first reduction in this balance in the past six weeks, as the Treasury Department increased this account by $426.1 billion between December 29, 2021 and February 2, 2022.

The US Treasury Department built up funds in its general account in the first five weeks of this year, a move that reduces the amount of funds in the banking system, and the Fed has purchased securities on the open market to compensate for this. accumulation.

Over the past week, the Treasury Department has been overseeing a reduction in its balances and the Federal Reserve has not felt the need to offset this move.

And, it should be noted that the effective federal funds rate remained stable at 0.08% throughout the banking week.

Remember that the Fed has kept the effective federal funds rate constant at 0.08% since September 1, 2021.

The Fed and Inflation

The latest news from the inflation front is not good news.

The consumer price index rose 7.5% year over year, the largest annual increase in 40 years. You have to go back to the Paul Volcker years to find this kind of inflation.

In addition, the core price index, year over year, was 6.0%.

And, analysis of the price data showed that the price increases were spreading to goods that were not majorly affected by the effects of the pandemic, and also spreading to the service sector, areas that indicate that higher inflation rates will last longer than initially thought.

In other words, inflation should now be higher and last longer than Federal Reserve officials initially thought.

This, of course, puts more pressure on the Federal Open Market Committee, the group that actually determines the Fed’s monetary policy.

Until now, investors had assumed that the Fed would stop reducing its monthly securities purchases by mid-March.

Shortly after the tapering ended, the Fed was expected to raise its key interest rate. The initial signal on this was that the Fed would raise the policy rate “band” by 25 basis points, from 0.00% to 0.25%, to 0.25% to 0.50%.

Now Fed leaders say the increase should be 50 basis points.

This could take the effective federal funds rate from 0.08% to around 0.60%.

The thing is, there’s a lot of talk about what the Fed is going to do, given reports that inflation is not only worse than initially thought, but higher rates may last longer than expected. .

Market rate

What change has taken place in the last month.

A month ago, around January 11, 2022, the yield on the 2-year US Treasury was around 0.90% and the yield on the 10-year US Treasury was around 1.75%.

On Thursday, February 10, these yields at the close of the day were approximately 1.60% for the 2-year note and 2.05% for the 10-year note.

These are not minor increases for a month.

The Federal Reserve is facing significant market pressure to see its key rate increase.

But, unfortunately, that’s not all.

Currently, reserve balances with Federal Reserve banks, the proxy for excess reserves in the commercial banking system, hover around $3.8 trillion.

The banking system is overwhelmed with liquidity.

The Fed has indicated that it will manage this by not buying securities in the near future and letting the Fed’s securities balance sheet mature and fade away.

But, there is another problem besides this.

The Federal Reserve has sold more than $1.9 trillion of securities in the repo market. Yes, the Fed has $1.9 trillion in reverse repurchase agreements on its balance sheet.

What will the Fed do with this account during this period?

The Fed had no comment on that account and what will happen as the holdings portfolio dwindles.

The sale of securities in the repo market removes reserves from the banking system. The Fed apparently oversaw the increase in this account to reduce reserves in the banking system, thereby offsetting the reserves it was putting in the banking system by its purchase of $120.0 billion of securities each month.

In other words, while the Fed was pumping $120.0 into bank reserves each month, it was simultaneously overseeing a massive increase in reverse repurchase agreements to pull reserves out of the banking system.

Why do you ask?

Well, that’s how the Fed has been able to keep the effective federal funds rate constant at 0.08% since September 1, 2021.

Now, however, we have the dilemma that the Fed has all these “rests” on the balance sheet and needs to do something with them in its effort to “fix” its balance sheet to effectively fight inflation.

What dilemma?

Go forward

The Federal Reserve has a lot of work to do.

The Fed has worked very hard to get the United States into the position it is in now.

She still has her work cut out for her if she plans a serious fight against inflation.

This is one of the problems with central banking: if at one point you lean too far in one direction to achieve your short-term goals, very often you end up having to lean in another direction later on. to compensate for the damage done at that time.

The Federal Reserve, as I have said many times before, has followed the government’s policy of “credit inflation” for some 60 years to keep the unemployment rate as low as possible.

The debt has accumulated.

Then the pandemic hit. The Federal Reserve acted to forestall a crisis, but then acting under the mantra of always erring on the side of monetary easing, the Fed went even further to protect the economy from a “crash” that could plunge the economy in a much worse crisis.

And, the stock of debt in the economy has exploded.

Well, it seems like it’s time to “fold the other way”.

The problem is that the financial system and the economy are in such disarray and imbalance that returning to more stable times seems like a chore.

But, the Fed brought us here. Now it’s time for the Fed to bring us back to a period of greater calm.

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