NEW YORK (TheStreet) -- The Federal Reserve may not have decided yet when to raise interest rates, but it's already laying the groundwork for a possible move later this year.
Behind the scenes, the central bank is quietly reducing the amount of money sloshing through the banking system. It needs to do that because if there's too much money available for banks to lend, raising interest rates won't have much impact.
This extra money, which is called excess reserves, has been pumped into the banking system since the 2008 financial crisis to keep credit loose and help the economy grow. Now that the economy is almost ready to thrive on its own, the Fed needs to start withdrawing some of that money. Thus, over the next several months the Fed will start reducing "excess reserves" from the banking system.
To measure "excess reserves," look at the section of the Federal Reserve balance sheet called "Reserve Balances with Federal Reserve Banks." This can be found weekly on the Federal Reserve's H.4.1 statistical release. As of February 11, 2015, reserve balances with Federal Reserve banks amounted to just under $2.6 trillion. On September 3, 2008, just before the financial system started having troubles, reserve balances stood at $3.8 billion.
Notice the former number is in trillions and the latter number is in billions. The Fed doesn't need to return to the earlier number, especially with all the uncertainty that exists within the markets and the world. But, some reduction must take place.
Right now, "excess reserves" are near their historical high. This is one reason why short-term interest rates are so low -- there is a lot of "cash" hanging around in the banking system
The Fed has already begun to do this. Since October 15, 2014 when reserve balances peaked, the Fed has removed $263 billion in reserves from the banking system.
The Federal Reserve has lowered these excess reserves in a slow, deliberate way, trying not to upset the banks and their desired reserve positions. The heave achieved this reduction using reverse repurchase agreements and "term" deposits. These "tools" have short maturities so that the Fed can reverse itself at any time if the banks seem to be resistant.
The Fed has not moved at all to reduce the size of its securities portfolio because doing so would be harder to reverse and might be the cause of a possible disruption to the operations of the banks.
The Fed will continue to reduce these reserve balances using the short-maturity instruments until it sees that the banks are comfortable with what is going on. When it reaches this stage, then the Fed will begin to reduce its portfolio of securities bought outright.
The Fed has achieved this reduction while going through one of the most seasonally difficult times of the year to do such things, the holiday period between Thanksgiving and Christmas. During February and March, the Fed has a little more settled time to continue to reduce reserves before the April tax-paying season comes upon us. In the next two months, I believe that the Fed will continue to reduce reserves by as much as it can using the methods described above and might even, if conditions are right, start to reduce the size of its securities portfolio. This, of course, is something to look out for.
Then after the April-May seasonal swings, the Fed can continue reducing excess reserve into the summer months getting itself ready for time it feels it is appropriate to raise short-term interest rates.
One thing that will help the Fed to reduce the excess reserves without disturbing the banking system is that most of the excess reserves seem to be held by large banks. These larger financial institutions would, of course, find it easier to adjust their portfolios than would the smaller banks, and would be willing to live with fewer cash assets than would the smaller institutions.