The Federal Reserve has seen little or no demand pressure in the money markets over the past six months or so. Consequently, the Fed has not had to add securities to its portfolio during this time to combat any pressure for interest rates to rise.
The Board of Governors of the Federal Reserve System met last week and decided not to change the current stance of monetary policy, although the Board felt that it needed to be alert to any possible needs for additional monetary stimulus if the economic growth appears to be decelerating or if the unemployment situation seems to be deteriorating.
My read on this is that the Federal Reserve believes that it can do little more than what it has already done to try and stimulate further economic growth or lower unemployment. However, it says that it needs to stand ready in case the situation gets worse.
This is basically the same policy the Federal Reserve has been following for the past year.
To me the most important monetary variable to watch at this time is the excess reserves held by the banking system. This is very important for two reasons. The first is that I believe that the excess reserves statistics tells us something about what is going on in the banking system and the money markets. To understand what is going in the banking system and the money markets is important because the primary target the Federal Reserve is focusing on at this time is the Federal Funds rate and what is going on with respect to excess reserves tells us something about what is happening to the supply and demand for funds in the Fed Funds market.
Federal Reserve policy right now is to keep the Federal Funds rate between zero and 25 basis points. It has been focusing on this range since late 2008.
In attempting to keep the Federal Funds rate within this range, the Fed has been very successful. The effective Federal Funds rate, the actual funds rate times the quantity of funds lent at the each rate, gives us a weighted average of where the funds rate was trading each day. Over the past year the effective Federal Funds rate has traded between a low of 6 basis points and a high of 19 basis points.
The demand side of the market represents the need of the commercial banking system for additional reserves. The supply side of the market is dependent upon the Federal Reserve System supplying funds or withdrawing funds from the market to keep the Federal Funds rate from within the range it is aiming for.
My reading of the movement in the effective Federal Funds rate for the past year is this: the effective Federal Funds rate was relatively level, around 8 basis points, during from August 2011 into January 2012, roughly the first six months of the year. After January the rate increased up to the middle of July when it reached 19 basis points and then dropped off to about 14 basis points where it now resides.
The important question, especially for this past six months is the reason for the rise in the effective rate…was it because of demand pressures coming from the banking system…or, was it because of supply conditions created by Federal Reserve actions.
In terms of overt actions during this six-month period, the Federal Reserve did little or nothing. In fact, the securities portfolio of the Fed actually declined by about $16 billion from May 2, 2012 to August 1, 2012.
What did put reserves into the banking system, however, was general operating factors, in this case the Treasury, writing checks on its Federal Reserve account, and these checks were then deposited in the banks. At tax time, April, taxes are paid into government accounts at commercial banks and then drawn into the Treasury’s General Account when the Treasury is going to write checks. In order to minimize the disruptions in the banking system, the Treasury attempts to keep its deposits there as constant as possible. Thus, its General Account at the Federal Reserve can experience wide swings during tax time and afterwards.
The Treasury’s General Account at the Federal Reserve fell by $84 billion between May 2 and August 1.Thus, the reserve balances of commercial banks at the Federal Reserve rose by about $60 billion during this time period and excess reserves in the banking system rose by about $37 billion. So the Federal Reserve acted in a relatively passive way during this time period although the banking system gained in excess reserves during the time period. The Effective Federal Funds rate did rise over this same time period, but was the rise demand driven?
My belief is that there might have been a little demand pressure during this time period but I don’t think that the pressure was substantial. Certainly there has been some pickup in bank lending over the past six months, but the bank loan demand remains relatively tepid. Most of the loan demand was in business loans at the 25 largest banks in the United States and these banks are highly liquid. There would little need for them to go to the money markets to finance the loans.
Evidence that there was not much demand side pressure over this time period is that the Fed actually reduced its holdings of market securities. The little pressure that might have been felt in the Fed Funds market was probably due to the where government checks were paid and the consequent slight dislocation of short-terms funds within the banking system. The back off in the effective Fed Funds rate this past week is evidence that these funds are well distributed and the banking system is comfortable with how reserves are distributed throughout the industry.
One further note on the excess reserves situation: total reserves in the banking system actually declined by about 7 percent over the past year. At the same time, required reserves in the banking system rose by just under 28 percent. These figures capture the huge movement of funds in the financial system from money market funds and other short-term assets back into the banking system, primarily into transactions balances. This movement has resulted in the M1 money stock increasing at very high, historical, rates of growth, but this increase is coming from individuals and businesses moving assets around and not from loan growth that is underwriting economic activity. Monetary policy is just not doing much these days except keeping the banking system liquid and helping the FDIC continue to close banks without disrupting financial markets. I believe very strongly that the Federal Reserve could achieve very little more in this economy if it opened up the monetary spigots much further. The Open Market Committee was right in keeping monetary policy unchanged.