EC Is The Fed Surreptitiously Tightening?

The following chart shows that on a monthly closing basis, bank reserves held at the Fed peaked in August of 2014 at $2.79T and by August-2016 had shrunk to $2.35T. This amounts to a $440B decline in bank reserves over the space of two years. Furthermore, $320B of this $440B decline happened since last October. Does this mean that while the financial world vigorously debates whether the Fed will/should take a ‘baby step’ along the rate-hiking path next week, behind the scenes the Fed has been tightening the monetary screws for 2 years and especially over the past 10 months?

In a word, no. Up until now the Fed has done nothing to tighten monetary conditions.

I am, of course, aware that there was a tiny increase in the Fed’s targeted interest rate last December, but this rate hike was not implemented via a money-supply or reserve reduction and therefore did not constitute genuinely-tighter monetary policy. What, then, is the explanation for the significant reduction in bank reserves held at the Fed?

Before getting to the explanation I’ll reiterate that there are only three ways for US commercial bank reserves to decline. They can be converted to physical currency in circulation in response to increasing demand on the part of the public for notes and coins, they can be shifted to other accounts at the Fed, or they can be removed by the Fed. Only the last of these constitutes monetary tightening by the Fed.

Part of the explanation for the decline in bank reserves is the increasing demand on the part of the public for notes and coins. Due to “inflation”, this demand increases almost every year and is satisfied by the conversion of reserves into physical currency. This naturally has the effect of reducing bank reserves, but the process does not change the money supply because the physical currency replaces electronic currency. For example, when you withdraw $100 at an ATM, $100 is converted from electronic form to paper form while the total money supply is obviously unaffected. This $100 of ‘paper’ comes from the bank’s reserves.