QQQ - Federal Reserve Watch: Flush With Funds

2023-05-19 14:20:25 ET

Summary

• The Federal Reserve continues to reduce the size of its portfolio of securities held outright. Quantitative tightening has been going on for more than a year now.
• Still, however, there is a lot of liquidity in the banking system, an amount that may take to Fed a longer time to succeed in the quantitative tightening.
• But, the M2 money stock continues to decline; it is down now 5.2 percent year-over-year.
• But, the banking system is still flush with funds.
• The Federal Reserve may have further to go to "fight inflation" than was originally thought.

The Federal Reserve continued to reduce the size of its securities portfolio in the banking week ending May 17, 2023.

The securities portfolio declined by $29.9 billion.

This brings the total decline since the end of the banking week of March 16, 2022 to $719.1 billion.

Including the accounting for the discounts or premiums included in the portfolio, the overall decline in securities totaled $771.8 billion.

However, the reserve balances with Federal Reserve Banks, roughly the excess reserves in the banking system, jumped up by $54.7 billion.

Since March 8, 2023, these reserve balances have risen by almost $280.0 billion as the Federal Reserve has done its share to protect the banking system from the bank failures that hit the banking system around that time.

Here is the picture of what has happened to "excess reserves" in the banking system since March 8, 2023.

Not particularly the rise beginning on March 8. 2023.

Even though the Fed continued to raise its policy rate of interest after the rise began in March, the banking system apparently needed reserves to help keep the money markets calm.

Here is the picture of the Fed's securities portfolio.

This chart represents the foundation of the Fed's policy of quantitative tightening.

The Federal Reserve has overseen the constant decline in the dollar amount of securities it holds outright on its balance sheet.

Notice the steady decline is now in its 14th month.

Mr. Powell and the other Federal Reserve leaders have been true to their word...the decline in the dollar value of the Fed's securities portfolio has steadily declined for more than a year.

Right now, the Fed is aiming to continue to reduce the size of the securities portfolio for an indefinite time.

Managing The Balance Sheet

Still, one must look at these two line items together.

The Federal Reserve is reducing the size of its securities portfolio...securities held outright...but it is also managing the money market to protect against disruptions that might come from the banking system itself.

In this respect, the loans the Fed has made to the banking system as some commercial banks faced failure has put just over $285.0 billion into the banking system.

Furthermore, the federal government, since the beginning of the quantitative tightening, has reduced the deposit balances it holds at the Federal Reserve by almost $630.0 billion. When the federal government reduces its deposits at the Fed, these monies go to increase the bank reserves in the country.

To offset this, the Fed has accepted about $735.0 billion in reserves through its reverse repurchase facility where it sells government securities under an agreement to repurchase them in a very short time.

Net of all these transactions, reserve balances have recently been rising, too, as the Fed has kept the money markets on an even keel.

So, there is a lot going on that the Federal Reserve has to manage in order to achieve its overall goal.

And, one could argue that these other "distractions" are keeping the Fed from tightening up on the banking system even more than it has done.

So, one can argue that the Fed is continuing with its policy stance of tighter money, but the real question is whether or not the Fed has removed as much liquidity from the banking system to achieve what it really wants to do...to fight inflation.

The Liquidity In The Banking System

The commercial banking system still has about $3.3 trillion in excess reserves in the banking system.

So, even though Federal Reserve officials can point to the fact that it has been very steady in reducing the size of its securities portfolio, there still remains an excessive amount of "excess reserves" in the banking system.

It should be noted that these excess reserves, as I have discussed in other recent posts, seem to be located in the largest 25 domestically chartered commercial banks in the country and in foreign-related banks.

Cash assets appear to be lowest in the small- and middle-sized banks in the United States. And, it seems as if the "middle-sized" banks are the ones that are now experiencing the most trouble in staying solvent. This is where Silicon Valley Bank of SVB Financial Group (SIVBQ) and Signature Bank (SBNY) come from.

The largest commercial banks in the country, especially the largest six banks, seem to be in the best shape and also are producing historically high profits . And, the largest six banks have massive amounts of cash on their balance sheets.

This raises the question about the Fed's efforts to continue on with the quantitative tightening. If the Fed continues on reducing the size of its securities portfolio, will that have a greater negative impact on the small- and medium-sized banks in the country?

If this is so, will there be more bank failures? Will there be more "smaller" banks being taken over by the largest banks? Will this change the structure of the American banking system?

These, I believe, are major questions that Federal Reserve officials will have to face.

M2 Money Stock

The M2 money stock continues to decline. On April 18, 2022, the M2 money stock was reported to be $22,032.2 million. On April 2, 2023, the Fed reported the M2 money stock to be $20,877.6 million. This represents a decline of 5.2 percent.

Here is the chart of the M2 money stock over the past year.

Many analysts are pointing to the fact that this is one of the largest year-over-year declines in the money stock in history.

One can ask about this picture, is the decline so large because the rise in the M2 money stock was so large on the other side of the dip?

Let's look at that side.

Wow! A lot of money was created in the time period just previous to the time that money stock growth turned negative.

Is there just a lot of "liquidity" washing around the financial system trying to find a place to settle?

If this is true, the Federal Reserve may have a lot more work to do to return things to something "more normal."

It seems that we may be a lot further from a solution to our current dilemma than perhaps had been thought.

Maybe this is going to take more pain than originally expected.

Maybe we have a long way to go.

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