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Fed Looks to Reduce Excess Reserves in the Banking System

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The Federal Reserve is in a precarious situation.  They have an enormous amount of excess reserves in the banking system and this helps to keep money market interest rates very low.  The Federal Reserve knows that short-term interest rates are going to have to rise sometime soon.  Rising short-term interest rates will impact the fixed-income bond markets.

Right now, it looks like the Federal Reserve has chosen a path to reduce the amount of excess reserves that are available to the banking system.  This is apparently the way the Fed is going to move the system down the road to rising interest rates.

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On the Fed’s latest H.4.1 statistical release, the level of reserve balances at Federal Reserve banks was at $2.486 trillion.  On June 25, 2014, the last report from the first half of the year, reserve balances were at $2.628 trillion.

The Federal Reserve continued its policy of Quantitative Easing through the end of October, but it still was “testing the waters” in terms of how it might ultimately reduce the amount of excess reserves it has pumped into the banking system.

The consideration to reduce the amount of excess reserves in the banking system is a very sensitive subject for the officials at the Federal Reserve.  After the Great Depression in the 1930s, the economy was recovery…although not at a very rapid pace…but it was on the upswing.  At that time, officials at the Federal Reserve observed that the banking system had built up quite a few excess reserves.

The situation at that time was not the same as the period we have just gone through in that the Federal Reserve had not engaged in anything like the three rounds of quantitative easing that it has just gone through in the current time of economic recovery.

The excess reserves came about because the commercial banks were not lending much and any reserves the Fed put into the banking system seemed to go into excess reserves.  The officials at the Fed thought that the excess reserves were just causing the money markets to be “sloppy” and they did not like that.  The Fed officials, at that time, like to keep the money markets right on the edge of too little liquidity so as to maintain control of what was going on in the financial system.

So, in order to reduce the excess reserves and get the money markets back on the desired “edge”, the Federal Reserve raised the reserve requirements of the banking system.  The problem was that commercial bank management’s desired the level of excess reserves they had achieved and when the Fed raised the reserve requirements the banks moved to restore the excess reserves they maintained.  The result?  The banking system lent out even less, the money stock collapsed…and the economy was thrown right back into another depression…the depression of 1937-38.

Officials at the Federal Reserve do not want to see something like this happen again.  So, while it is making an effort to reduce the excess reserves in the banking system, it is doing so very cautiously because it doesn’t want to upset the banking system and cause a regression back into another financial crisis.

For one thing, the Fed is not going to raise reserve requirements this time to reduce the excess reserves in the banking system.  For, another, the Fed is not going to start selling securities outright to reduce the excess reserves.  If, for whatever reason, the Fed had to reverse itself, it would be very difficult to have to purchase a massive amount of securities to replace the ones that it had just sold.  Furthermore, selling securities is an action the Fed would initiate…and, the Fed wants to proceed in a fashion that relies on what the banks want to do.  Acting in this way means that the Fed would be doing something only the banks want it to do and would not be imposing its will on bank actions.

The two methods the Fed is using to reduce the excess reserves in the banking system relate to repurchase agreements and term deposits.  The first of these is an old tool, and, from the Fed’s viewpoint is really a repurchase agreement.  On the Fed’s balance sheet the line item is called reverse repurchase agreements, stating the way the account looks from the standpoint of the government securities dealer who is buying the securities from the Fed.

In these transactions the Fed sells the government security to the government securities dealer under an agreement to repurchase the securities at the end of a given time, at a given price.  It is a short-term transaction, but it has the same impact, while the trade is alive, as an outright sale of the securities.

The Fed operates in this way to not put too much pressure on the bond markets.  And, since these transactions are always unwinding, it means that the Fed isn’t faced with the need to start repurchasing securities if the banking system needs the liquidity.

The problem, from the Fed’s perspective is that it needs to keep renewing the repurchase agreements over and over again to maintain the lower level of excess reserves it is shooting for.

The other “tool” the Fed is using is called “term deposits held by depository institutions.”  The Fed offers these deposits to banks on a regular basis.  The banks respond to the offer by submitting bids for a given amount of money.  The banks get an interest-bearing asset in exchange for reserve balances at a Federal Reserve bank and the Federal Reserve gets a liability…not unlike the liability created by the repurchase agreements.  Excess reserves go down.

Again, the term deposits are just short-term…eight days or so…in nature so the Federal Reserve must continuously roll them over again to maintain a given amount of term deposits on its balance sheet.

On November 19, 2014, the Fed’s balance sheet included $167.8 billion reverse repurchase agreements and $307.7 billion in term deposits.  One year ago, the Fed began working with the repurchase agreements again and on November 20, 2013 the Fed’s balance sheet only included $6.1 billion in reverse repurchase agreements.  The Fed did not actively use the term deposits as a way to reduce reserve balances until May of this year.  At the end of May, May 29, the balance sheet only included $27.6 billion in term deposits.

So, we see that even though the Fed continued to purchase securities from the open market through the summer and up until the end of October, it had already begun using these other tools to begin withdrawing reserves from the banking system.

So, over the past year, but mostly in the last four months, the Federal Reserve has removed roughly $470 billion in reserves from the banking system by means of these short-term operational transactions.

The Fed will continue to use these tools to continue to reduce reserve balances held at Federal Reserve banks for the near future…as long as the removal of these reserve balances do not disrupt the operations of the commercial banks.  My guess is that it will continue to do so until pressures are starting to be felt in the money markets and short-term money market rates begin to rise either because the Fed has removed sufficient reserves from the banking system so that they don’t want to lose any more or because loan demand picks up sufficiently so as to cause banks to want to lend the money out to corporations and not to the Fed.

This is how the Fed seems to be taking us into the future when interest rates begin to rise.  The Fed wants to do this in as smooth a fashion as possible.  We just need to keep our eyes on the Fed to see how the “exit” operation is progressing.

About John Mason John MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.

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