It seems to me that the main thing that Federal Reserve officials are focusing on is their key interest rate.
On September 1, 2021, Fed officials locked in the effective federal funds rate at 0.08%.
On March 16, 2022, the effective federal funds rate was moved to 0.33%.
Now, Fed officials are talking about raising their key interest rate range by 50 basis points at their next Federal Open Market Committee meeting in mid-May.
Here’s how disciplined the Federal Reserve has been since September 1 of last year.
A fifty basis point increase would put the effective federal funds rate around 0.83%.
What about the Fed’s balance sheet? What about the securities portfolio? What about reverse repurchase agreements?
Well, Fed officials say they will present plans for these operating accounts after the FOMC meeting in May.
But, we can have everything we really want to know with the Fed talking about where it’s going to take the fed funds rate. And, so far, they have been very disciplined in controlling the effective federal funds rate.
So when Fed officials say there will be at least two more increases in the policy range of the federal funds rate this year, it appears to be the driving force behind their policy efforts.
As for the balance sheet and the securities portfolio, well, the “forecast” is that the Fed will do what is necessary with these in order to achieve the fed funds rate that they are going to aim for.
The Key: Reserve Balances at Federal Reserve Banks
The key variable in maintaining the effective federal funds rate is the balance sheet account titled Reserve Balances with Federal Reserve Banks.
This variable can serve as a proxy for the excess reserves of the banking system. As these reserve balances increase, it means commercial banks have more “excess liquidity” available, which tends to put downward pressure on the effective federal funds rate.
If this account falls, commercial banks have less “excess reserves” on their balance sheets, which tends to put upward pressure on the effective federal funds rate.
Here we see what has happened to those reserve balances since the start of 2021.
First, we see these “excess reserves” increasing, which should mean that the banking system had significant reserves and that the pressure on short-term interest rates should be lower.
The effective federal funds rate was falling in the first part of the year and by August was approaching zero.
Federal Reserve officials did not want the effective federal funds rate to go negative, so they decided to keep the rate above zero.
The first peak in these reserve balances occurred on September 1, 2021. In other words, the Fed decided to keep the effective federal funds rate at 0.08% and ensured that banks’ “excess reserves” did not not increase.
From September 1, 2021, reserve balances remained relatively constant, but around December they began to decline.
On January 3, 2022, you can see how excess reserves in the banking system began to decline.
The Standard & Poor’s 500 stock index reached its last all-time high on January 3, 2022.
We can also see that reserve balances also fell around mid-March, when the effective federal funds rate rose to 0.33%.
Thus, the Federal Reserve reduced the amount of “excess reserves” in the commercial banking system in order to meet its needs by raising the Fed’s key interest rate.
Federal Reserve stocks
Since the end of 2021, reserve balances with Federal Reserve banks have shrunk by just over $710.0 billion.
The Fed was buying even more securities for its portfolio during this period, which placed deposits in the commercial banking system, but three other factors accounted for the large drop in “excess reserves.”
First, the US Treasury Department transferred over $690.0 billion to its general account at the Federal Reserve. It took money from the banking system and put it into the Federal Reserve Banks.
Second, the Fed has engaged in more than $170.0 billion in reverse repurchase agreements. This sale of securities, under a short-term buy-back agreement, also took money from the commercial banking system, even if only for a short time.
Third, nearly $35.0 billion in cash left the banking system and went into the private sector.
Thus, we see that since the beginning of the year, the Fed has supervised a substantial reduction in “excess reserves” in the banking system. and that helped explain the increase in the effective federal funds rate.
As seen in the last chart above, there was a substantial decline in reserve balances following the March move in the policy rate.
Since March 16, 2022, reserve balances with Federal Reserve banks have fallen by $565.9 billion. This explains the support of the new higher interest rate.
Note that securities held by the Federal Reserve actually fell by $14.7 billion in the last banking week, resulting in a $9.1 billion drop in total securities held since March 16. 2022.
The main cause of the decline, however, came from the liability side of the Fed’s balance sheet, as the US Treasury moved more than $335.0 billion into its general account at the Fed, and reverse repurchase agreements increased. over $225.0 billion.
Note, however, that over the past banking week, reverse repurchase agreements have actually declined! The amount was only $72.7 billion, but that was a drop!
So here we are in May.
We look forward to a 50 basis point increase in the target range for the fed funds rate.
And we look forward to a reduction in the Fed’s balance sheet to support this hike in the key interest rate.
How does balance sheet reduction really matter?
I think so. My concern is that the Fed now has nearly $2.1 trillion in reverse repurchase agreements on its balance sheet.
To put the Fed in a more stable position going forward and to keep a possible tool at the Fed’s disposal, reverse repurchase agreements need to be reduced by a fairly substantial amount.
So in my mind it is important to understand what the Fed is going to do with this “tool”.
However, we may be in a period where it may be much more important to “see” what the Fed is doing, rather than listening to what it is saying.
One thing seems certain. Short-term interest rates are rising.