The Fed’s new lower bound problem
Can Jerome Powell take away the toys without tears?
The Fed intends to start to reduce its balance sheet next week, 1st June. How will Quantitative Tightening (QT) affect policy and markets? A key to that question is knowing the lower bound of liquidity demand. We don’t know that limit because we can’t measure it and things could get dysfunctional if we breach that limit. This is the Fed’s new ‘lower bound problem’.
A bit of history. Lehman’s bankruptcy in 2008 prompted the Fed massively to increase credit to banks, which was then progressively replaced by purchases of assets – a mixture of mortgage-backed securities agency bonds and treasury securities. On the liability side there was a massive increase in bank deposits at the Fed, known as Reserve Balances. That shift marked the start of a new approach to policy by the Fed and continues to define how policy interacts with banks twelve years later.
It is common to focus on the asset purchase side as the driver of policy. Makes sense; buying bonds to push down rates seems an obvious policy choice with rates floored at zero. Yet as the primary balance sheet of the US banking system, it is just as valid to think in terms of how changes in Fed liabilities affect markets. After all, central bank liabilities are the foundation of the currency.
In the system that operated before 2008, any liquidity shortage in the banking system would be filled by the Fed. As the adjustment was frequent, the demand for Fed cash was low, and relatively stable. The shortage system revealed the exact level of liquidity needed by the banking system at every auction.
Since the advent of the surplus system, precise measurement of liquidity demand isn’t possible because liquidity is no longer regularly sampled. The fear is that like a frustrated parent the Fed has offered the banking system a huge box of toys in the hope of keeping the peace. Maybe, like spoiled children, the banks won’t want to give back their toys. It is safe to assume that most extra toys are not just sitting in the toy-box.
The flow of reserves between banks via the FedWire Fund Service has risen in line with the stock of reserves held at the Fed. The growth in reserves served, partly, as a replacement of the dysfunctional interbank market, specifically as a medium of settlement. What had previously been a private, often unsecured settlement became secured on the safest of safe money. The total stock of reserves at the end of March 2020 was USD 3.8 trillion; the average daily turnover of FedWire Funds Service in March was USD 4.3 trillion. Turnover in FedWire has risen in line with total securities transactions. Investors invest, banks settle using FedWire.
We can guess where pressure is likely. Daily turnover of the capital markets is split between outright purchases and some form of repurchase agreement (repo). Repo now turns over a higher daily dollar value than outright asset purchases in US markets and repo is crucially dependent on the level of reserves. The biggest user of repo through the FedWire system are money market funds. How money-market funds react to balance sheet reduction is going to determine how repo behaves and will be a key measure of QT’s effects.
The Fed have an answer of this. In July 2021 they introduced the Standing Repo Facility to provide liquidity should repo rates rise unexpectedly. A repeat of the 2019 ‘repo crisis’ should be avoidable. Maybe that’s enough. But pre-emptive palliatives are all as we can expect. There is no sign the Fed, or anyone else, fully understands how all the bits of financial plumbing fit together in the ‘excess reserves’ system. Repo may be fine, but blockages may easily appear somewhere else.
Why? Because the ‘velocity’ of financial market settlements using reserves acts as the lubrication for market prices. The Fed does not completely control the allocation of those reserves. They may hope money market funds behave as expected, but recent developments suggest that faith may be misplaced. Contrary to expectations, money market funds have not reduced their holdings at the Fed. Instead they have increased them, diverting reserves away from the banking system.
This is the Fed’s new ‘lower bound’ problem. For sure there is a level of reserves below which settlements of securities and repo becomes constrained. No-one knows that level. If you’re going to take the toys away, let’s hope the kids don’t burst into tears.