The securities portfolio of the Federal Reserve continues to decline.
Although the decline in the last banking week was not that great, given portfolio adjustments, the Federal Reserve has seen the reduction in its securities since March 16, 2022 reach just over $430 billion.
This amounts to an average decline of about $43.0 billion per month.
Overall, reserve balances with Federal Reserve Banks have fallen by a little over $775.0 billion. These balances represent very liquid commercial banking assets held in the banking system, and their decline is consistent with the rise in the Fed’s policy rate of interest.
In essence, “excess reserves” in the commercial banking system have fallen by about $78.0 billion per month since the Fed began its current effort to tighten up on monetary policy.
This monthly decline is roughly consistent with the Fed’s plan to conduct a “quantitative tightening” of monetary policy beginning in March 2022 and extending through the end of 2023.
If the Federal Reserve continues at this pace through the end of this year, it will have removed another $858.0 billion from reserve balances in the banking system, bringing the total reduction in reserve balances to $1,634 billion or just over $1.6 billion.
I focus on this number because this “quantitative tightening” is the real essence of the Federal Reserve’s effort to fight inflation.
The specific rise in the Fed’s policy rate of interest is of secondary importance.
This “quantitative tightening” is the Fed’s response to the “quantitative easing” that took place during the economic recovery from the Great Recession and the efforts of the Fed to protect the U.S. economy from the consequences of the spread of the Covid-19 pandemic.
Remember when Chairman Jerome Powell and the Federal Reserve, in the spring of 2020, began to purchase $120.0 billion in securities every month, a program that continued through the end of 2021?
The program was built on the idea that this kind of quantitative easing could keep the U.S. economy from falling into a financial collapse, one that was generated by the destruction of the pandemic.
The ideas behind quantitative easing came from Fed Chairman Ben Bernanke, who was the inventor of this approach, and who oversaw three rounds, QE1, QE2, and QE3, while he was still in charge of the Federal Reserve.
As Mr. Bernanke describes in his latest book, “21st Century Monetary Policy” (W. W. Norton & Company, 2022), a policy of quantitative easing is aimed at stimulating a rise in stock prices, a rise that would create a wealth effect among consumers leading to more and more expenditures driving the economy ahead.
Mr. Bernanke’s policy creation now seems to be the vehicle that the Powel administration is using to slow down economic growth and break the back of inflation. The reduction in the reserve balances of the commercial banking system must be steady, must be in force for an extended period of time, and create a wealth effect…a decline in stock prices…sufficient to slow consumer spending and slow the rise in the Fed’s choice of a consumer price index.
The question is, how far can the Fed continue this quantitative tightening?
How great of a decline in stock prices can the U.S. economy absorb?
But, this seems to be the plan.
The Federal Reserve Balance Sheet
Here is what the Fed has accomplished so far.
Note two things here.
First, note the constant rise in the Fed’s holding of securities. This is what happens under “quantitative easing.”
The securities held in the Fed’s portfolio rise into March 20232
Second, the securities held in the Fed’s portfolio begins to decline after that. And, note that the pace of decline is relatively steady.
Now let’s look at what happened to reserve balances held by Federal Reserve Banks during this period.
This series is, obviously, not as smooth as the earlier chart. The earlier chart only considers securities held in the Fed’s securities portfolio.
This series, reserve balances with Federal Reserve Banks includes the movement of all other assets and liabilities that are on the Fed’s balance sheet, things like the General Account of the U.S. Treasury Department, and Currency in Circulation.
So, there are a lot of factors influencing reserve balances, but, you can clearly see the impact of the changes in the Fed’s securities portfolio on this series.
Before March 2022, the Federal Reserve was executing a policy of quantitative easing. Reserve balances with Federal Reserve Banks were rising.
After March 2022, the Federal Reserve was executing a policy of quantitative tightening.
Reserve balances with Federal Reserve Banks are declining.
The fight against inflation goes on.
Going forward, I believe that one should focus primarily upon what the Federal Reserve is allowing to happen with respect to its securities portfolio and to the measure reserve balances with Federal Reserve Banks.
Yes, what happens to the Fed’s policy rate of interest is important, but the foundation of the Fed’s current fight against inflation is the “quantitative tightening” that it is generating.
The recent news about the drop in the consumer prices index to a 6.5 percent, year-over-year rate of increase resulted in article after article in the press and on TV about how this news would impact the Fed and change the rate at which it was raising its policy rate of interest.
My real concern is about whether or not the information will cause the Fed to alter its program of quantitative tightening.
I don’t think this recent news will cause the Fed to alter its quantitative tightening.
That is what is really important!
So, keep your eyes on the Fed’s balance sheet and not just on what it says or does with its policy rate of interest.