Due to the great concern over how the Federal Reserve plans to reduce its balance sheet from $2.2 trillion to something comparable to the level it was at in August 2008, something around $900 billion, I will be posting on a regular basis my analysis of how the Fed is withdrawing funds from the banking system and the financial markets.

The concern about having put too many funds into the banking system is one about future inflation. The argument here is that it takes a while for inflation to build up. But, as the credit bubble earlier created by the Fed earlier this decade ended up in the financial collapse of 2008-2009, the fear is that if all the reserves the Federal Reserve has put into the banking system remain there, inflation will become a factor in 2010 and beyond.

The concern about removing the funds from the banking system too quickly comes from the 1937-1938 experience where commercial banks had a large quantity of excess reserves on their balance sheets. The Federal Reserve, at that time, raised reserve requirements to establish “tighter control” over the bank activity. However, the large amount of excess reserves on hand was consistent with the conservative behavior of the banks. The increase in reserve requirement caused banks to be even more conservative resulting in a substantial decline in the money stock. The result was the depression of 1937-1938.

For the two weeks ending September 9, 2009, depository institutions held $823 billion of excess reserves. Cash assets in the commercial banking system totaled slightly less than $1.0 trillion. In August 2008 these figures totaled less than $2.0 billion for excess reserves and around $300 billion for cash assets. Reserve balances with the Federal Reserve totaled about $860 billion on September 16, 2009; and this figure was about $50 billion on September 17, 2008.

It is an understatement to say that a lot of liquidity has been injected into the banking system!

Over the past 13 weeks ending on Wednesday September 16, 2009, reserve balances with Federal Reserve Banks increased by almost $120 billion. This increase alone represented a jump of about 13% of the Fed’s balance sheet one year earlier, so one cannot deny that the rise in reserve balances is not insignificant. The Federal Reserve is still acting in BIG NUMBERS, the size of which would have been incomprehensible 18 months ago!

Dissecting what took place during this time, however, is crucial to an understanding of how the Fed is trying to extricate itself from the situation it now finds itself in without setting off another panic in the financial markets. There were three basic changes in the Fed’s balance sheet over this time. The first change was operational in a seasonal sense and hence not crucial to the reduction in the Fed’s balance sheet. The second change is important because it relates to what is happening to all the special assets and facilities that the Fed set up to combat the financial crisis. These accounts appear to be phasing out. The third change relates to how the Fed is replacing the reserves draining out of the banking system because of the second change. Here the Federal Reserve is getting back into open market operations, something it abandoned in December 2007 as it created the Term Auction Facility (TAF).

The first major change in the balance sheet over the last 13 weeks was the swing in the general deposits the U. S. Treasury holds with the Fed. The movements here were seasonal and therefore solely of an operational nature. This swing has to do with tax receipts and the Treasury writing checks. The Treasury and the Fed have worked out operations so that tax collections and government expenditures do not disrupt the banking system any more than necessary. As a consequence you can get some pretty large swings in the balances that the Treasury holds at the Fed in this account without these movements causing large swings in the reserves that are in the banking system. Over the 13 weeks ending September 16, 2009, Treasury deposits declined by over $60 billion: however, in the last 4 weeks ending on the same date these balances increased by $32 billion. All this was handled smoothly.

It is the second of these factors that is vitally important for the exit strategy of the Fed. Accounts that can be associated with the “unusual” activities engaged in by the Fed over the last 21 months declined by over $300 billion over the last 13 weeks. The amount of funds supplied through the TAF dropped by over $140 billion. The net portfolio holdings of Commercial Paper Funding Facility LLC fell by almost $90 billion. Funding supplied through central bank liquidity swaps declined by more than $87 billion. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility fell by about $19 billion.

In other words, the Federal Reserve is letting these facilities decline at their own pace as the need for them recedes. Even with all these reductions, however, one can still account for almost $600 billion of the Fed balance sheet being associated with assets created for the specific needs that officials perceived were necessary to keep the banking and financial system from collapsing. So there is still a ways to go to return to normalcy.

The Fed is replacing these assets that are running off with the purchases of various kinds of open market securities. Over the past 13 weeks, the Fed has increased its portfolio of securities held by about $385 billion. (One should note that in the first week of September 2008 the Fed held “total” less than $800 billion in securities. Again the magnitudes are staggering!) Of this increase, $121 billion was in Treasury securities, $35 billion was in Federal Agency securities, and $229 billion were in Mortgage Backed securities. (Note that on September 16, 2009, the Federal Reserve held $685 billion in Mortgage Backed securities, about 88% of the “total” securities held by the Federal Reserve in the first week of September 2008.)

My best guess about how the Fed will reduce its balance sheet is as follows. (Note that I am not including in this analysis any effort on the part of the Fed to support the massive amounts of debt that will be created through the deficits of the federal government in the future.) The portfolio of Treasury securities and Federal Agency securities will not be an active part of the Federal Reserve exit strategy. In my mind, what the Fed would like to see happen is that the roughly $600 billion is “special” assets would “run off” over time without major difficulty. Then, as the market for Mortgage Backed securities stabilizes and then returns to a more normal pattern of activity, the Fed will either allow its portfolio of Mortgage Backed securities to run off or will sell them into a strengthening market and significantly reduce the size of its holdings of these securities. As mentioned above, the Fed’s portfolio of Mortgage Backed securities totaled $685 billion on September 16.

Thus, assuming the best of all worlds, if these two items on the Fed’s balance sheet were eliminated, this would account for almost $1.3 trillion. Take away $1.3 trillion from the $2.2 trillion of assets on the Federal Reserve balance sheet September 16 and you get roughly $900 billion. On September 10, 2008 the Federal Reserve balance sheet totaled a little more than $900 billion in assets!

Can the Fed do it? We’ll just have to wait and see. It is important for us to see that there is a logical path out of the dilemma the Federal Reserve is facing. However, there are many potential bumps along the path. The health of the economy is one. The ever increasing federal debt is another. Recovery around that world is also a factor. And so on and so on. We will continue to watch!