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Economy in Brief

The Fed Giveth and the Fed Taketh Away, Reserves
by Paul L. Kasriel  October 13, 2021

This is a follow-up to my August 27, 2021 commentary, Fed Chair Powell's Taper Talk Is Much Ado About Nothing (available in Haver's archives of the Viewpoints section and on my LinkedIn page). The weaker-than-expected (?), seasonally-adjusted September nonfarm payrolls with continued soaring average hourly earnings notwithstanding, the Fed is expected to begin tapering its outright purchases of securities in November. But because the Fed is not planning to simultaneously raise the federal funds rate, this tapering is, to quote Shakespeare, again, “a tale … full of sound and fury signifying nothing”. To wit, as the Fed cuts back on its purchases of securities, which has the effect of cutting back on the Fed's provision of bank reserves, it will also cut back on its granting of reverse repurchase agreements, which has the effect of draining bank reserves. Thus, the post-taper change in bank reserves will be the same as the pre-taper change in reserves, assuming banks' demand for reserves has not changed. The Fed can control the supply of reserves or the level of the funds rate, but not both simultaneously. So, if you believe that the level of the federal funds rate is the be all – end all of monetary policy, then the Fed's tapering of its securities purchases will not change monetary policy. If you believe as I do that it is the growth in combined Fed and banking system credit that matters most in terms of monetary policy, then, again, the Fed's tapering will not change the thrust of monetary policy.

Let's look at how reserves in the banking system have behaved in recent months in the face of no change in the amounts of securities the Fed has been purchasing outright. Plotted in Chart 1 are the 26-week dollar changes in securities purchased outright by the Fed and the 26-week dollar changes in reserves owned by depository institutions (banks) held at the Fed. In the 26 weeks ended October 6, 2021, the Fed's outright holdings of securities increased by $800.3 billion. But bank reserves increased by only $223.5 billion.

Chart 1

Since March 15, the Fed's target range for the federal funds rate has been 0.00 percent to 0.25 percent, with a midpoint of 0.125 percent. Presumably, however, the Fed does not really want the federal funds rate to trade below 0.05 percent. I say this because as the average federal funds rate fell to 0.05 percent in the week ended June 2, on June 17, the Fed raised the rate on which it was willing to borrow reserves on an overnight basis from the financial system from 0.00 percent to 0.05 percent, or 5 basis points. The Fed borrows reserves by offering to temporarily sell securities to financial institutions in an operation called a reverse repurchase agreement. When the Fed purchases securities, this adds reserves to the banking system. When the Fed sells securities, this drains reserves from the banking system. The biggest factor draining reserves in recent months has been reverse repurchase agreements. As mentioned above, since mid June, the Fed has been willing to borrow reserves overnight at a rate of 0.05 percent. This has put a floor under the federal funds rate. So, as the federal funds rate starts to fall to 0.05 percent or less, financial institutions offload their excess reserves to the Fed, which drains reserves from the financial system and causes the federal funds rate to rise above 0.05 percent. Chart 2 shows that in the 26 weeks ended October 6, outright purchases of securities by the Fed (the green bars) were $800.3 billion, which, all else the same, added $800.3 billion of reserves to the banking system. But in that same period, Fed reverse repurchase agreements (the blue line in Chart 2) drained $1,465.7 billion reserves from the banking system, all else the same. If all else had, in fact, been the same, then reserves would have contracted by $665.4 billion ($1465.7 billion minus $800.3 billion) during this 26-week period. But all else was not the same inasmuch as reserves increased on net by $223.5 billion (the red line in Chart 2). The biggest factor offsetting the draining effect of reverse repurchase agreements was an $859.1 billion decline in US Treasury deposits at the Fed, which had the effect of adding a like amount of reserves.

Chart 2

The upshot of all this is that if the Fed is not going to allow the federal funds rate to rise as it begins tapering its outright purchases of securities and if banks' demand for reserves does not fall, then the Fed is going to have to offset the smaller additions to reserves via outright purchases of securities with increases in reserves from some other element. In all likelihood the Fed will either cutback on its draining of reserves via reverse repurchase agreements or it will have to increase reserves via regular repurchase agreements. Under these circumstances, the Fed's upcoming taper operations will be much ado about nothing regarding the sum and substance of monetary policy.

However, the taper might lead to a rise in the yield on TIPS, Treasury Inflation-Protected Securities. As Chart 3 shows, in the 19 months ended September 2019, the net increase in TIPS outstanding (the blue line) was $146.4 billion. During this same time period, the Fed acquired $231.7 billion TIPS (the red bars) or all of the Treasury's issuance plus $85.3 billion more. At the end of September 2021, the Fed owned 21.9% of the outstanding stock of TIPS. In March 2020, the yield on the 5-year TIPS was minus 0.12 percent. By September 2021, this yield had dropped to minus 1.53 percent. The TIPS market is relatively small and, therefore, relatively illiquid. Thus, small changes in supply or demand can have magnified effects on yields. The fact that the Fed bought up $85.3 billion more than the total net issuance in the 19 months ended September 2021 likely suppressed the yield on TIPS all else the same. So, to the degree that the Fed pares its purchases of TIPS, the yield on TIPS could be expected to rise, again, all else the same.

Chart 3

In the 19 months ended September 2021, the Fed had acquired $2,641.0 billion of the Treasury's net issuance of $3,518,7 billion of nominal coupon securities. At the end of September 2021, the Fed's holdings of the outstanding stock of nominal coupon Treasury securities were just 0.3 of a percent. The nominal coupon Treasury securities market is the second most liquid in the world; the Treasury bill market being the most liquid. So, it is unlikely that the Fed's purchases of nominal coupon Treasury securities had much impact on their yield levels. If so, then the Fed's prospective tapering of purchases of these securities would not likely have much impact on their yields either.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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