Federal Reserve Watch: Moving Into The New Year

The Federal Reserve has now been combatting inflation for almost ten months.

The Federal Reserve has raised its policy rate of interest seven times in 2022, beginning on March 16, 2022.

But, the crucial, underlying action of the Federal Reserve is the reduction it is achieving in the amount of securities purchased outright that remain on the balance sheet of the Federal Reserve.

Balance sheet data are found on the Fed’s weekly release H.4.1, Factory Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.

Since March 16, 2022, the Federal Reserve has overseen the reduction in securities purchased outright of $428.6 billion (including the accounting for the net of premiums and discounts on securities held outright).

How the Fed has performed in this area is represented by the following chart.

The reduction in the Fed’s portfolios of securities held outright is the “foundation” of the Fed’s efforts to reduce its securities portfolio, a portfolio that increased by about $4.5 trillion during the quantitative easing program the Fed undertook to combat the disruptions coming from the spread of the Covid-19 pandemic.

The Federal Reserve is trying to return to some earlier form of “normalcy” in the composition of its balance sheet in order to help put a stop to rising prices.

Reserve Balances

The Federal Reserve is trying to reduce the size of its securities portfolio in order to reduce the amount of liquidity that exists within the banking and financial system.

The Fed’s line item, Reserve Balances with Federal Reserve Banks, is a sort of proxy for the excess reserves in the banking system.

If reserve balances go up, as they did when the Fed was pumping money into the commercial banking system, the Fed’s policy rate of interest will tend to go down. This is what happened as the Fed fought the impacts of the pandemic’s spread.

Now, the shoe is on the other foot, and as the Fed withdraws reserves from the banking system, the Fed’s policy rate of interest is rising.

In the accompanying chart, the reader can observe how the Fed has overseen the decline in reserve balances since the beginning of the fight against inflation.

Since the Fed statement of March 16, 2022, reserve balances with Federal Reserve Banks have declined by $851.5 billion.

Bottom line, the Federal Reserve, since March 16, 2022, has overseen a massive outflow of liquidity from the commercial bank system.

This is, to me, the essence of the Fed’s quantitative tightening program.

Note that on January 4, 2023, the banking system carries with it $3.0 trillion in excess reserves.

This is way too many excess reserves, and the Fed is trying to do something about them.

But, it is going to take time and patience for this number to get anywhere close to what excess reserves were before the pandemic.

That is why the Fed, realistically, has a long-term battle ahead of it.

But, back to the current story.

Impacting The Economy

The Fed’s policy of quantitative tightening is working itself through the banking system and the economy.

Note, the following chart pictures the movement in the M2 measure of the money stock.

The M2 money stock measure reflects the interaction of the banking system with the economy.

Remember that the Federal Reserve really started to move on the monetary system in the middle of March 2022.

By the end of April, the M2 money stock began to decline.

The decline has continued since then.

But, let’s look at the picture a little bit differently.

Let’s extend the chart back to the 1960s.

In no other segment of the performance of the M2 money stock do we see a halt in the growth of the M2 money stock like we have seen over the past seven months.

It would appear from this chart that the Fed’s actions have been sufficiently tight so that the M2 money stock has been in decline for at least seven months.

What does this mean?

Is this an indication that the economy is going to slow down in the very near future and drop down into a relatively severe recession?

Or maybe, given all the liquidity shoved into the banking system over the past two years…as can be painfully seen in the chart…that the “slowdown” will just be an adjustment to less liquidity in the system?

Or, maybe some other development will result from the Fed’s former actions.

Approaching A Brink?

It appears to me that the Fed has, so far, stuck to its promises and maintained a relatively steady pressure from its quantitative tightening, from its efforts to reduce the size of its securities portfolio.

But, the Fed, in my opinion, still has much more it needs to do.

And, the environment in which the Fed is operating is one of radical uncertainty.

In this environment, we just don’t know what all the possible outcomes might be, let alone the outcomes we think we know.

There are quite a few known unknowns in this environment, but there are still a number of unknown unknowns that must be faced.

The Federal Reserve, I believe, is currently doing alright, but we cannot give up our close observance of what is happening, what the Fed is doing, and anything new that appears in the picture.

I just have the feeling that the near future is not going to be all that pleasant.

But, we shall see.