Now that the US Federal Reserve has gone into full quantitative tightening mode, reversing an asset-buying program that had expanded its balance sheet to nearly $9 trillion, a worry is emerging: Could a disruptive cash crunch ensue, along the lines of what happened in money markets a few years ago?
Don’t be too concerned. This time around, the Fed is much better prepared.
True, the Fed has ramped up the asset runoff to its maximum rate of $60 billion of Treasuries and $35 billion of agency mortgage-backed securities each month. As intended, this will drain liquidity that had been added to support the economy during the Covid pandemic, gradually reducing the more than $3 trillion in cash reserves that commercial banks are holding at the Fed.
Doomsayers argue that reserves will eventually fall below the banking system’s needs, causing interest rates to spike in the crucial repo market, which hedge funds and other institutions depend upon to finance securities – a repeat of the September 2019 turmoil that forced the Fed to abandon abruptly its previous effort at quantitative tightening. They point out that almost $3 trillion in reserves have already been siphoned off: more than $2 trillion to the Fed’s reverse repo facility, which takes cash in from money market mutual funds, and another $600 billion in the form of the Treasury’s large cash balance at the Fed.
Let’s start with the reverse repo facility. Institutions such as money-market funds are using it heavily now, because the Fed pays a higher interest rate (2.3%) than what they can earn by lending money in private markets. This removes reserves from the banking system, parking the money directly at the Fed. But as quantitative tightening drains excess liquidity, private market rates will firm, and banks will increase deposit rates to lure customers away from money-market funds. Together, this will reduce usage of the Fed’s facility and boost reserves, postponing the moment when they become inadequate.
The Fed has also acted on the lessons of the last money-market disruption in two crucial ways. For one, it has set up a standing repo facility to limit any interest-rate spikes: If reserves become unduly scarce for any reason, banks can replenish them by borrowing at a slightly elevated rate, against the collateral of Treasuries and other government-guaranteed debt.
Beyond that, the Fed intends to shrink reserves more carefully this time around, in three distinct phases. We’re now in the first stage, where reserves decline relatively quickly along with the runoff of the Fed’s assets. In the second and third stages — when reserves fall to 10% and 9% of gross domestic product, respectively — the asset runoff will slow and then cease. The final target will be 8% of GDP, which the Fed will maintain by managing its holdings of securities. That target, of course, can change: The ultimate aim is to ensure that the supply of reserves is always slightly above banks’ underlying demand.
Quantitative tightening might not prove quite as boring as “watching paint dry,” as Janet Yellen suggested in 2017, but it’s unlikely to cause any major disruptions. As the Fed’s balance sheet shrinks and the amount of Treasuries in private hands increases, bond yields should rise modestly. That’s about it.
Bloomberg News provided this article. For more articles like this please visit
bloomberg.com.
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