Reserve balances with Federal Reserve banks, cash balances that the commercial banking system holds with the Fed, fell $71.3 billion last week. This account is in some way an approximation of the excess reserves of the banking system.
Since March 16, 2022, when the Federal Reserve really began to “tighten” monetary policy, reserve balances have fallen by nearly $660.0 billion.
It was this drop in “excess reserves” in the banking system that supported the Fed’s efforts to raise its key interest rate, the federal funds rate.
As can be seen in the following chart, the Fed raised its key rate three times during this period.
In 2022, the effective federal funds rate was 0.08%. From March 16, the rate rose to 0.33%. On May 5, the rate jumped once again to 0.83%. And, on June 15, the rate was raised to 1.58%.
We can see how the Fed moved reserve balances lower in order to reduce liquidity in the banking system and support the rise in the effective federal funds rate.
Note that although the decline in reserve balances began in January, the actual decline did not occur until late March as the Fed decided to encourage a hike in the key rate.
So the first part of the Fed’s effort to tighten monetary policy is pretty much on track.
Another key rate hike is expected at the Fed’s Federal Open Market Committee meeting this month. The base bet is on a 75 basis point rise in the policy rate range.
But, with the very high inflation rate in June, some people suggest that the key rate could be increased by 100 basis points.
July’s decision will be watched very closely to see how determined Federal Reserve officials are to show the investing community that they are very, very serious about tackling the current rate of inflation.
The second strategic objective: the securities portfolio
The other part of the Fed’s efforts to tighten monetary policy has only just begun.
The Fed’s second objective is to reduce the size of its securities portfolio.
The effort to reduce the size of the securities portfolio was not supposed to start at a very high pace and is supposed to be achieved, not by outright sales of securities, but by allowing the securities to mature off the Fed’s balance sheet without them all being replaced by the Fed.
The current reduction really seems to have started in June.
Since the end of the June 22 banking week, the amount of securities on the Fed’s balance sheet has shrunk by just under $33.0 billion.
This is happening, given the Fed’s modus operandi of outright buying securities to put on the Fed’s balance sheet, at a slow but relatively steady pace.
After the first two months of relatively small portfolio reductions, the decline will be steeper.
The decline in the securities portfolio is expected to continue in 2024.
As can be seen from this graph, the Federal Reserve continued to maintain its holdings of securities at a high level until June of this year.
Thus, the Fed began the second part of its monetary policy tightening effort, but it did not go very far in executing the movement.
The Federal Reserve is moving forward as it has indicated.
The investment community now believes that the Fed is currently fighting inflation.
The dilemma now is how much the Fed will actually enforce its “tighter” monetary policy.
Looking at the behavior of the stock market and the bond market over the past few weeks, there seems to be a good number of investors who believe that the Federal Reserve will actually only be “tight” for a minimal amount of time. and that over the next six to twelve month period, the Fed can “back off” from its “restrictive” policy and move to a more dovish stance.
There seems to be enough of these investors that the stock market seems reluctant to drop, and the inflation expectations embedded in government bond yields seem to mirror the moves that appear in the Federal Reserve’s FOMC economic projections.
There is yet another group of investors who think this picture is too soft.
These investors believe that inflation will remain a serious problem, that it will not be brought under control in the very near future and will force the Federal Reserve to keep its foot on the pedal for an extended period.
This group sees a lot more pain in the future.
But, as mentioned above, the group that sees an easier path ahead of us is the group that seems to be dominating the markets right now.
This is one of the reasons, I believe, for the heightened volatility in the stock and bond markets at the moment.
What story should I lean on right now?
I am in the latter group, and I have been in the latter throughout this period of rising inflation.
The economy, I believe, is in substantial imbalance.
It will take time and effort to bring the US economy back to a “more normal” state and, unfortunately, I believe there will be a lot of pain in getting there.
Therefore, I think the Fed needs to stay on a tighter path over the next year.