JOHN MASON: What is the "new normal"?

John reviews the progress of balance sheet reduction by the Fed, given the circumstances they had to take into account.

What is the "new normal"?

The Federal Reserve System has almost completed nine months of its operations to reduce the size of its securities portfolio. The program began on October 1, 2017.

On Wednesday, September 27, 2017, the Federal Reserve held $4388.5 billion in securities and net unamortized premiums on its balance sheet.

On Wednesday, June 23, 2018, the number had dropped to $4248.3 billion, which represented a decline of $140.2 billion in the securities portfolio.

The projected decline through the first nine months of the program was $180.0 billion.

Note that the Federal Reserve is not selling off securities. It is letting the securities in its portfolio mature off the balance sheet according to the natural aging of the securities and then buying back securities from the open market to achieve its desired reduction. In this way it causes as little disruption to the financial markets as possible.

At the beginning of October 2017, the policy range of interest rates for the Federal Reserve was 1.00 percent to 1.25 percent. The current target range for the policy rate of interest is now 1.75 percent to 2.00 percent. The policy range has been raised by 25 basis points three times since the securities portfolio reduction program began. Rate changes came in December 2017, March 2018, and June 2018.

Given that there is a little more than one week to go before the end of the first nine months of the program, one could argue that the Federal Reserve has done a pretty good job of staying on schedule in reducing its securities portfolio.

The Fed is a little under plan, but all-in-all, I think that they have done a really good job. This is because the Fed must take account of market conditions and all the operational factors that it must deal with on a regular basis.

Overall, Reserve Balances at Federal Reserve banks, roughly the excess reserves that commercial banks keep on deposit at the Fed, have declined by $227 billion since the securities reduction program began.

To give you some perspective of what Federal Reserve officials are dealing with, before the Great Recession began, in the fall of 2007, the total value of the Fed’s balance sheet amounted to a little more than $900 billion. Thus, the $227 billion reduction in reserve balances sine this program began nine months ago totals about 25 percent of the Fed’s total balance sheet before the beginning of the Great Recession!

During this past nine months there has been some substantial swings in some of the Federal Reserve’s accounts, things that the Federal Reserve has to deal with in its regular operations.

For example, since September 27, 2017, Currency in Circulation has risen by $81.5 billion. This means that $81.5 billion in coin and currency left the commercial banking system in the last nine months that was not replaced by the Federal Reserve System. This results in a direct reduction in commercial banks’ Reserve Balances at Federal Reserve banks…a reduction in “excess reserves.”

Furthermore, the Federal Reserve has stopped using reverse repurchase agreements as its major tool of monetary actions. As a consequence, the balances in this account have dropped by $220.0 billion, which put this amount of funds into commercial banks’ Reserve Balances.

To offset this, the amount of US Treasury deposits with Federal Reserve banks has risen to offset this reduction in reverse repurchase agreements. The offset has just about been one-for-one.

Things are not going to get any easier for the Federal Reserve going forward.

For example, it has been reported that commercial banks, specifically the larger ones, are planning to increase dividend payments and stock buybacks by $170 billion over the next twelve months, if the banks pass the stress tests being administered to them by the Federal Reserve.

Well, all of the biggest banks passed their stress tests and thereby stand ready to return these funds to their shareholders. These funds will one way or another come out of the cash reserves held by the commercial banks, cash reserves that should lower the amount of reserves the banks hold at the Federal Reserve.

Another headwind the Fed will be facing is the growing federal debt resulting from the tax reform bill that was passed in the US Congress last December and the budget bill that was passed early this year. This will add a substantial amount of government securities coming to the financial markets along with the securities that the Fed is allowing to mature off its balance sheet without replacing.

And, this includes any other disruptions that might impact markets, like problems coming from the emerging nations of the world refinancing their debt, or difficulties being experienced in the European Union because of the political difficulties building up there.

Bottom line, I think that the Federal Reserve has done a tremendous job this year reducing the size of its securities portfolio. Jerome Powell, the new Chairman of the Board of Governors of the Federal Reserve System has every intent, I believe, to continue the process.

Mr. Powell seems calm and reserved and wants to carry this demeanor over into the financial markets as he proceeds to lead the Fed though this program of reducing the Fed’s portfolio.

How far will the program go?

Well, beginning in July 2018, the Fed is scheduled to increase to amount it reduces the portfolio each month to $40 billion. That is, the plans are for the Fed to reduce its portfolio by $120 billion in the third quarter of 2018.

Then in October 2018, the amount is to rise to $50 billion each month or $150 billion for the fourth quarter. And, the $50 billion per month is projected to continue until Federal Reserve officials decide that it is the right time to abandon the reduction program.

It is, of course, uncertain about how great the reduction will end up being and it is also uncertain how small the Fed’s balance sheet will actually become. I think that it is an impossible task to try and guess these amounts.

The important thing is for the Federal Reserve to return the balance sheet to a size that will provide the commercial banking system with sufficient liquidity for it to conduct its business effectively and smoothly while at the same time keeping liquidity sufficiently low so that the Fed can control the banking system to achieve its goals and objectives.

On September 3, 2007, just before the Great Recession began, the amount of Reserve Balances at Federal Reserve banks totaled just over $4.0 billion. On June 20, 2018, Reserve Balances totaled just under $2,000 billion.

There is a lot of room between these two numbers. What is the “new normal”?

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