This is the third post in a series designed to review the progress of the Federal Reserve in its efforts to exit the position it has created for itself by more than doubling the size of its balance sheet. (The first two posts in this series appeared on August 21 and September 18.) Some fear that if the Fed cannot reduce the size of its balance sheet that the amount of reserves that have been put into the banking system will explode in the creation of new credit which will be followed by an explosion in the various measures of the money stock. This can only be inflationary with substantial concern that such inflation could turn into hyperinflation.

The fear of many others is that the Fed will withdraw these funds too quickly thereby causing the banking industry further problems and the experience of a second financial collapse.

Bottom line: Reserve Balances with Federal Reserve Banks rose by $190 billion in the four weeks ending October 14, 2009. The rise over the last thirteen-week period was $244 billion. These Reserve Balances totaled $1,049 billion on October 14, a new record high! These data are taken from the Federal Reserve Statistical Release H.4.1.

Required reserves in the banking system averaged about $63 billion in the two banking weeks ending October 7. Excess reserves in the banking system, as reported in the Federal Reserve Statistical Release H.3 were $918 billion for the same period of time. Reserve Balances with Federal Reserve Banks were $963 billion on October 7.

Obviously, there are plenty of reserves in the banking system and the banks still do not seem to be in any mood to begin lending again. See my post on the lending activity in the banking system to support this conclusion: http://seekingalpha.com/article/165994-commercial-real-estate-lending-problems-hitting-the-smaller-banks.

Where did this $190 billion of new reserve balances come from?

Well, about $52 billion came from factors supplying reserves to the banking system and another $137 billion came from a reduction in factors that were absorbing reserve funds. For the thirteen week period, factors supplying reserves contributed $121 billion to the $244 billion increase and there was a $123 reduction in factors absorbing reserves. Let’s look at both in turn.

As was highlighted in the previous two reports on the exit strategy of the Fed, the monetary authorities continued to allow accounts associated with the special facilities created to deal with the financial crisis to run off. These reductions were offset by purchases of financial assets. This seems to be the first move strategy of the Fed to achieve its exit from the big buildup.

Over the past four weeks, there was a $61 billion decline in three asset categories connected with the new facilities that were created. The Term Auction Facility (TAF) declined by almost $41 billion, the portfolio holdings of Commercial Paper declined by $3 billion and the line item associated with Central Bank Liquidity Swaps fell by a little more than $17 billion.

Over the last thirteen weeks these three items declined by almost $260 billion: TAF dropped by $118 billion; the commercial paper facility by $71 billion; Central Bank swaps fell by $68 billion.

The Fed replaced these run-offs by open market purchases that more than covered the outflow, hence the overall increase in bank reserves. For example, Securities Held Outright by the Fed jumped $103 billion in the last four weeks and by over $360 billion in the last thirteen weeks.

The Fed is therefore allowing the special facilities to decline where possible and is then maintaining the liquidity of the banking system by purchasing securities in the Open Market!

In purchasing securities in the open market the Fed is buffing up the liquidity in these markets and helping to keep interest rates low. Of particular note, the Fed has added $78 billion in Mortgage-Backed Securities to its portfolio over the last four weeks and $237 billion over the last thirteen. The Fed has purchased Federal Agency Securities in recent weeks: this portfolio has increased by $11 billion and $35 billion in the last four and thirteen weeks, respectively.

Two other items of note: first, something called Other Federal Reserve Assets rose by $6 billion over the last four weeks and by $13 billion over the last thirteen weeks. What is in this account? Well, the Federal Reserve states that this account includes Federal Reserve assets and non-float-related “as-of” adjustments. These may include Assets Denominated in Foreign Currencies or Premiums Paid on Securities Bought. We don’t really have any information on the totals, but these amounts are relatively substantial amounts, especially when the required reserves in the banking system only total $63 billion.

The second item that requires some attention is that the Special Drawing Rights (SDR) account at the Fed increased by $3 billion over the last four weeks. Actually the increase came in the banking weeks ending September 23 and September 30. Thus the Special Drawing Rights certificate account at the Federal Reserve rose from $2.2 billion to $5.2 billion during this period. I am going to have to do more research into this increase and what it means.
In the meantime here is a definition of the SDR: SDRs were originally created to replace Gold and Silver in large international transactions. Being that under a strict (international) gold standard the quantity of gold worldwide is finite, and the economies of all participating IMF members as an aggregate are growing, a purported need arose to increase the supply of the basic unit or standard proportionately. Thus SDRs, or “paper gold”, are credits that nations with balance of trade surpluses can ‘draw’ upon nations with balance of trade deficits. So-called “paper gold” is little more than an accounting transaction within a ledger of accounts, which eliminates the logistical and security problems of shipping gold back and forth across borders to settle national accounts.

The other major contributor to the rise in reserve balances at commercial banks was a movement out of federal government accounts at the Federal Reserve. There was a movement of $157 billion out of government accounts in the last four weeks and $149 billion in the last thirteen. A reduction in these accounts takes place when the government disburses money and the funds end up as bank reserves. In terms of the governments’ general account, the movement of funds, in and out of this account, is usually connected with seasonal tax collections and disbursements.

There is another account that saw a large reduction, $100 billion, over the last four weeks. This was in an account called the U. S. Treasury Supplementary Financing Account. The Fed defines this account in this way: “With the dramatic expansion of the Federal Reserve’s liquidity facilities, the Treasury agreed to establish the Supplementary Financing Program with the Federal Reserve. Under the Supplementary Financing Program, the Treasury issues debt and places the proceeds in the Supplementary Financing Account. The effect of the account is to drain balances from the deposits of depository institutions, helping to offset, somewhat, the rapid rise in balances that resulted from the various Federal Reserve liquidity facilities.” Thus, a movement out of the Fed injects deposits into depository institutions.” We need more information on this decline.

To conclude: The Fed continues to reduce dollars associated with the new facilities created to combat the financial crises. It is replacing these dollars with open market purchases that keep the banking system liquid. Other transactions have also taken place related to federal government disbursements that add reserves to the banking system. In restructuring its balance sheet the Fed is being sure to err on the side of being too loose in supplying bank reserves. Obviously, the leadership at the Fed does not feel that any type of constraint should be imposed upon the banking system at this time.

3210378500200629631-8638251989462192380?l=maseportfolio.blogspot.com