November 1, 2016
The Fed Began Tightening Policy in October and No One Knew It, Maybe Not Even the Fed
I am so old that I can remember when the Fed tightened policy without any public announcements, often between FOMC meetings. Sometimes it took several days after the Fed implemented the tightening for a consensus to develop among Fed-watchers that a tightening had, in fact, taken place. But, at least, the Fed knew immediately when it had implemented a tightening. I believe that the Fed commenced a stealth tightening of monetary policy in October. But one possible difference between this current tightening and the tightenings of yesteryear is that it is not clear that even the Fed realizes that a tightening has occurred of late.
The reason I believe that the Fed has tightened monetary policy is because of the deceleration in the growth of thin-air credit, that is, a deceleration in the growth of credit created by the Fed and the commercial banking system. One element of the Fed’s contribution to thin-air credit is the reserves created for the depository institution system. These reserves are held at the Fed. The other component of thin-air credit created by the Fed is the currency held by depository institutions in their vaults and the currency held by the nonbank public. Depository institution reserves held at the Fed and currency is often referred to as the monetary base. Depository institutions are commercial banks, S&Ls and credit unions. Commercial banks account for over 90% of the total assets of depository institutions. Depository institutions create thin-air credit by granting loans and purchasing securities. Plotted in Chart 1 are the 52-week annualized percent changes in the sum of commercial bank credit plus the monetary base from November 4, 2015 through October 19, 2016. From January 1960 through September 2016, the median year-over-year growth in this thin-air credit aggregate was 7.1%. From November 4, 2015 through October 19, 2016, the median 52-week annualized growth in this thin-air credit aggregate was 4.4%. In the 52 weeks ended October 19, 2016, the annualized growth in this thin-air credit was 2.8%. Annualized growth in total thin-air credit of 4.4% is weak in an historical context. 2.8% annualized growth is very weak.
Plotted in Chart 3 are the Wednesday weekly dollar levels of the monetary base from November 4, 2015 through October 26, 2016. You will notice two distinct plunges in the level of the monetary base. The first distinct plunge started in December 2015. This was when the Fed hiked its target federal funds rate level by 25 basis points. In order to get the federal funds rate to rise toward the Fed’s desired higher level, the Fed needed to reduce the supply of reserves available to depository institutions relative depository institutions’ demand for reserves. But why has the level of the monetary base plunged starting in late September 2016? The Fed did not raise its target federal funds rate level at the September 2016 FOMC meeting (although overnight bank funding costs have crept higher).
The net dollar change in the monetary base, consisting of liability items on the Fed’s balance sheet, in the six weeks ended October 26, 2016 was a decline of $277 billion. The net dollar change in Fed assets, largely securities owned by the Fed and discount window loans to depository institutions, during this period was a decline of $27 billion. So, the bulk of the $277 billion decrease in the monetary base must have been due to some other Fed liability items that absorb, or drain, funds from the financial system. One of those liability items that comes to mind is Fed reverse repurchase agreements with money funds and primary government securities dealers. When a money fund enters into a reverse repo with the Fed, the money fund, in effect, makes a short-term loan to the Fed, receiving as collateral for that loan some Treasury securities that the Fed has in its portfolio. A Fed reverse repo drains reserves, one of the components of the monetary base, from the depository institution system. To the money fund, entering into a reverse repo is a substitute for purchasing a Treasury bill. Both are short-term and both are guaranteed by the federal government. Chart 4 shows the behavior of Fed reverse repurchase agreements with money funds and primary government securities dealers from November 4, 2015 through October 26, 2016. Fed reverse repos shot up in late December 2015, presumably to reduce depository institution reserves in order to push up the federal funds rate to its higher desired level. But why did Fed reverse repos spike up in late September and early October of 2016?
The recent spike in Fed reverse repurchase agreements with money funds and primary government securities dealers might be related to a change in money fund regulations that went into effect in mid-October 2016. On July 23, 2014, the Securities and Exchange Commission amended Rule 2A-7 of the Investment Company Act of 1940. Rule 2A-7 pertains to the regulation of money market mutual funds. Among other things, the amendments to Rule 2A-7 require institutional prime and institutional municipal money funds to float their daily net asset values. That is, a prime money fund must mark-to-market the value of its assets daily rather than automatically valuing each share at $1.00. Money funds marketed to individual household investors, retail money funds, are allowed to continue valuing a share at $1.00. An institutional prime money fund invests primarily in non-government guaranteed short-term fixed-income securities such as commercial paper and large negotiable bank-issued certificates of deposit. The amendments to Rule 2A-7 allow institutional money funds that invest in government-guaranteed assets to continue valuing a share at $1.00. As mentioned, these amendments to Rule 2A-7 went into effect in mid-October 2016.
According to Investment Company Institute data, in the 52 weeks ended October 26, 2016, the total assets of institutional prime money funds declined by $774 billion. In this same time period, the total assets of institutional government money funds increased by $763 billion. One likely motivating factor for this shift out of prime money funds and into government money funds by institutional investors is the amended Rule 2A-7. Whatever the motivation for this shift in portfolio preference by institutional investors, the result has been an increase in demand for short-maturity government-guaranteed fixed-income securities. One important component of the supply of short-maturity government-guaranteed fixed-income securities, U.S. Treasury bills, has not kept pace with the increased demand. In the 12 months ended September 2016, the amount of Treasury bills outstanding increased by only $289 billion. But there is another source of supply of government-guaranteed short-maturity fixed-income securities available to money funds – reverse repurchase agreements with the Federal Reserve.
It is conceivable, then, that the money fund reforms incorporated in the amendments to SEC Rule 2A-7 might have inadvertently contributed to the recent Fed tightening of monetary policy by inducing money funds to step up their use of Fed reverse repurchase agreements, which drain reserves from the financial system. Of course, the Fed could have offset the drain in reserves resulting from the increased volume of reverse repos by injecting additional funds into the financial system through the Fed’s purchase of securities in the open market. But the Fed has not done this.
As mentioned above, in the six weeks ended October 26, 2016, the monetary base contracted a net $277 billion. During this same period, the increase in Fed reverse repurchase agreements with money funds and primary dealers accounted for a net $78 billion of the $277 billion decline in the monetary base. So, there must have been some other factor on the liability side of the Fed’s balance sheet that was contributing to the contraction in the monetary base. That factor is U.S. Treasury deposits at the Fed. When the Treasury receives revenues from tax payments and/or security sales, these receipts often first appear in the Treasury’s deposit account at the Fed. For example, when I pay my taxes, my checking account balance decreases by $X, my bank’s reserves at the Fed decrease by $X and the Treasury’s deposit account at the Fed increases by $X. Reserves have, thus, been drained from the financial system. If the Treasury is not immediately going to spend these additional funds, it often redeposits a part of its increased balances at the Fed with private depository institutions. This restores part of reserves that were previously drained from the financial system when the tax or securities payment were first deposited in the Fed’s account at the Fed. But to the degree that Treasury deposit balances at the Fed increase, reserves are drained from the financial system by that amount, all else the same.
For reasons not known to me, both the Treasury’s overall cash balance and its balance at the Fed have been increasing significantly starting in 2015. In the six weeks ended October 26, 2016, the Treasury’s deposit balance at the Fed increased a net $168 billion. The Fed could have injected reserves into the financial system through securities purchases to offset this $168 billion reserves drain from higher Treasury balances, but it didn’t. Rather, as mentioned above, the Fed let its assets decline a net $27 billion during this six-week period.
In the old days, before Fed policy change announcements, Fed-watchers, observing the monetary base declining and bank overnight funding interest rates rising (see Chart 5), likely would have concluded that the Fed had tightened monetary policy. But to the best of my knowledge, no one, including the Fed, has indicated as such. But in terms of the deceleration in the growth of thin-air credit and the drift up in overnight bank funding interest rates, the Fed has tightened monetary policy in recent weeks. What’s more, assuming that the October 2016 employment report, to be released Friday, November 4, is not a washout, the Fed is likely to formally tighten again at the conclusion of its December 13-14, 2016 FOMC meeting by announcing a 25 basis point increase in its target level for the federal funds rate. This will imply that the Fed will have to reduce the monetary base even more in order to push the federal funds rate up toward its new desired higher level. In turn, this will imply a further deceleration in the growth of thin-air credit from an already anemic current 52-week growth rate of 2.8%. Investors, get ready for slower U.S. economic growth in the first half of 2017. And Fed, get ready for a barrage of criticism from the administration of the next President, whoever it is.
Paul L. Kasriel
Founder, Econtrarian, LLC
Senior Economic and Investment Advisor