The Federal Reserve continues along in its efforts to keep the financial markets from convulsing into a real liquidity crisis. Not only are the leaders of the Fed trying to “plug holes” in financial markets by providing direct access to Federal Reserve funds to different segments of the market, but they are also constantly “talking up” what they are doing and what they think that they are accomplishing.

So far the effort has been received well by the financial community, and evidence of this “trust” is being shown in the buoyancy of the stock market and the bond market.

The Fed’s efforts have primarily been aimed at supporting the liquidity needs of the financial markets. In this, the Fed does not want to see a financial market collapse due to a shock or disruption that sends the market spiraling due to a lack of liquidity in a specific market or two.

These balance sheet efforts, however, do not deal with the potential for a solvency problem.

As I have just written, the solvency issue is beginning to raise its head. How this problem is dealt with remains to be seen.

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Balance Sheet Changes

Over the past two weeks, the Federal Reserve has actually overseen a reduction in commercial bank excess reserves. On the Fed’s balance sheet, “Reserve Balances with Federal Reserve Banks,” a proxy for the excess reserves in the banking system, have actually declined over the past two weeks by $206.2 billion.

There are three reasons for the decline in these reserve accounts: first, the deposits of the US Treasury Department in its General Account, the account the government writes checks from, have risen by $91.4 billion; Central Bank liquidity swaps have declined by $127.1 billion; and currency in circulation outside of commercial banks have risen by $12.1 billion.

These three changes resulted in a reduction in excess reserves of $230.6 billion.

Offsetting this amount was the continued purchase of US government securities and the increase in all the special lending accounts the Fed has set up to take care of specific financial market liquidity needs.

Longer-Term Balance Sheet Changes

Over the longer run, these accounts have been the major contributors to the expansion of the Fed’s balance sheet.

Since February 26, 2020, the end of the banking week that is closely related to the Fed’s move to provide liquidity protection for the financial markets due to the economic recession caused by the spread of the coronavirus pandemic, the excess reserves of the commercial banking system rose by $1,183.1 billion.

The overt action of the Federal Reserve over this period of time has been the Fed’s purchase of open-market securities. Since February 26, the securities portfolio of the Federal Reserve has risen by $2,278.6 billion.

Most of the funds created by these purchases have gone into the General Account of the US Treasury. In fact, over 55 percent of these funds, $1,269.1 billion, have gone into the General Account.

As I have argued before, these funds represent “ammunition” that the Treasury has at its hand to spend and stimulate the economy…roughly $1.3 trillion.

The two other major factors moving the excess reserve total is the central bank liquidity swaps account, up $225.4 billion since February 26 and the flow of currency in circulation out of the banking system in the amount of $171.9 billion.

Central bank liquidity swaps reached a high of $446.0 billion at one time and represent the effort that the Fed has made to provide liquidity to international financial systems to help keep the world going. The large outflow of cash from the banking system is something that always happens of financial and economic stress as people and businesses want to hold a lot more cash than usual.

What About Fiscal Policy?

Currently, there is great concern that the United States government needs to produce some more fiscal policy to stimulate the economy in order to generate sufficient activity to keep employment up and to provide some help to prevent a solvency problem.

As we read in the New York Times:

“There is a growing recognition across party lines that Congress will need to spend more money, and soon, to continue to prop up the American economy during the coronavirus recession.”

Some in the Wall Street Journal do not seem to be very optimistic about this happening:

“GOP lawmakers have for weeks paused work on another bill, electing to wait until after the July 4 recess to see how the economy recovers and decide what is necessary. But the twin developments Thursday of the U.S. setting a single-day record for new coronavirus cases and the Labor Department reporting that the U.S. economy added 4.8 million job in June has muddied the outlook for Senate Republicans.”

Consensus seems to be missing. Thus, there is little knowledge about what a package might look like and how quickly it might arrive. The most analysts can determine is that the next fiscal bill will spend far less to help people and businesses than the nearly $3 trillion that was approved by Congress in the hurried package that came out in March.

The concern is here that Congress does not get taken in by the good statistics that we have seen and postpone any actions until it is past the time when they could be most effective. The issue here is the possible move from the economy facing a liquidity crisis to one in which the economy faces a solvency crisis.

The Federal Reserve has moved dramatically to prevent a liquidity crisis, but it can be nowhere as effective in fighting a solvency crisis all by itself.

The Future

The Federal Reserve has done about all it can at the present time. What happens from here on out is highly dependent upon what the rest of the government does. But there is great concern here. There is some concern here that people in the global investment community are losing trust in how the rest of the government will respond. If the rest of the government does not adequately respond, there will be little more the Federal Reserve can do.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.