In 2019, the Fed cut interest rates and restarted quantitative easing despite a healthy economy. Today, it is above the Fed’s target, economic growth is above historical trends and financial markets are calm and exuberant.
Nevertheless, the Fed is talking about cutting interest rates and reducing the QT. The only reason for this is concern about possible liquidity problems, as shown by the declining balances in the Fed’s Reverse Repurchase Program (RRP).
Before we discuss the RRP and its potential impact, it is important that investors have a good understanding of the Fed’s monetary policy tools.
Why the Fed is so important to investors
Twenty to thirty years ago, very few investors needed to understand the Fed’s monetary policy. The Fed was undoubtedly important, but its actions were not nearly as closely followed or had as much influence as they do today. Today, the success of investors in real estate, stocks, bonds and almost all other financial assets depends on understanding the Fed’s inner workings.
Total debt is growing much faster than the economy’s total income. To deal with this divergence and avoid liquidity problems, the Fed has increasingly resorted to lower interest rates and balance sheet manipulation (QE). Numerous rescue packages for banks and investors also helped.
As debt increases, the importance of the Fed will increase.
Total Debt vs. Personal and Corporate Income
What is the RRP?
A repo is a loan secured by securities. The Fed’s RRP is a loan in which the Fed borrows money from primary dealers, banks, money market funds, and government-sponsored enterprises. The term is one day.
The program offers money market investors the opportunity to invest temporarily available funds.
What does the RRP do?
Think of the RRP as a money market offering that balances the supply and demand curves for short-term funds that banks and other financial institutions use.
During the pandemic, the Fed bought about $5 trillion in Treasury and mortgage bonds from Wall Street. This injected a huge amount of liquidity into the financial system. Because banks did not use all of the liquidity to make loans or purchase longer-term assets, financial institutions had excess liquidity that had to be invested in money markets. The result was downward pressure on short-term interest rates.
The Fed raised the federal funds rate to combat inflation. However, it was difficult to achieve the target rate given the excess liquidity in the market. Thanks to the RRP, the Fed was able to achieve its goal.
The current status of the RRP
At its peak, the RRP facility reached $2.5 trillion. Since then it has fallen continuously. It is currently half a trillion dollars and is likely to fall to almost zero in the coming months. Essentially, the market absorbs the excess liquidity. Last year, the Treasury needed excess liquidity to finance its rapidly growing debt and to help the market absorb the bonds taken off the Fed’s balance sheet through the QT program.
Excess liquidity is decreasing
Having liquidity problems at a time when liquidity is abundant is not that easy. The Fed’s extreme actions in 2020 and 2021 have made it much easier for the banking system, financial markets and economy to cope with significantly higher interest rates and a QT of $95 billion per month.
However, excess liquidity is decreasing rapidly.
What problems arise when excess liquidity is used up? First, banks will need to use their reserves to help the Treasury issue debt and offset the decline in the Fed’s balance sheet. Such actions result in liquidity flowing from other parts of the financial system to the Fed and Treasury. Without the RRP, banks will have to tighten their lending standards for consumer and business loans. In addition, they will likely reduce their margin lending to speculative investors.
The costs of higher interest rates and QT are then likely to become noticeable.
Review of 2019
In 2019, interest rates on Treasury-backed repo transactions between banks and other investors were significantly higher than interest rates on uncollateralized Fed Funds. Such a situation made no sense.
A hypothetical example: JP Morgan lent Bank of America (NYSE:) overnight at 5.50% with no collateral, while a hedge fund agreed to take out a loan at 5.75% fully collateralized by Treasury bonds. Yes, Bank of America has a better rating and lower risk of default, but the hedge fund offers risk-free collateral. Although the probability of JP Morgan losing money in this example is small, it is greater with the Bank of America loan than with the repo deal with the hedge fund.
Back then, the Fed raised interest rates and reduced its balance sheet over the last year and a half. Liquidity became a major problem. There was no RRP from which liquidity could be drawn to offset the QT. There was simply a lack of liquidity.
To combat the lack of liquidity, the Fed injected liquidity by lowering interest rates and renewing QE. These measures were taken when the economy was in good shape and financial markets generally gave little cause for concern.
The chart below shows when the Fed quickly changed course.
The year 2019 is significant in that similar problems could arise when excess liquidity caused by the pandemic eventually flows out of the system.
Fed prepares for liquidity shortages
The Fed appears to be aware of potential liquidity shortages. Last month she began discussing reducing monthly QT. A formal announcement could come as early as the March 20 FOMC meeting.
These discussions and planning are taking place even though inflation is still above target, the economy is growing faster than trend, and the stock market is near record highs. Under these circumstances, one would think that the Fed would stick to its tight monetary policy.
The Fed is aware of the fact that large institutional investors must sell assets to reduce leverage when there is insufficient liquidity. Such collective actions could have a significant impact on the prices of financial assets and ultimately on the economy.
Read a recent article from the New York Fed. In “The Financial Stability Outlook,” author Anna Kovner states the following
Achieving a strong U.S. economy and stable prices is paramount, and awareness of the impact of policy decisions on the financial system is an important prerequisite for maintaining policy capacity. To close with the snow metaphor I started with, if there’s a snowstorm in March, we’ll be ready to quickly shovel ourselves out, clear the streets, and get back to work.
March is not a random date. The RRP program is expected to drop to almost zero in March!
Does the Fed know when liquidity will no longer be “abundant”?
There is no magic number or calculation that tells the Fed when excess liquidity will run out. It will also only know when liquidity is no longer plentiful if the money markets react negatively.
Dallas Fed President Lorie Logan recently made this clear. In a speech on March 1, 2024, she said:
The challenge now is how far to go in normalizing the balance sheet. In 2019, the Federal Open Market Committee decided to work in the long term with a version of the fractional reserve system in which reserves are “abundant.” The word “abundant” means that the banks’ demand is met conveniently but efficiently. As I have argued elsewhere, the Friedman rule provides a guide to the efficient provision of reserves in a reserve-sufficient system. Banks’ opportunity cost of holding reserves should be approximately equal to the central bank’s cost of providing the reserves.
She continued:
I don’t think we can set a level that seems “abundant” in advance. We have to approach it by observing money market spreads and volatility.
Summary
Excessive debt supports our economy and asset valuations. Therefore, the Fed has no choice but to keep the liquidity pumps pumping to support debt.
As in 2019, the Fed is likely to adopt stimulus measures to provide liquidity despite an economic and inflationary environment in which policy should remain tight.
Keep a close eye on the Excess Liquidity Indicator (RRP) and watch out for irregular activity in the money markets.
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2024-03-08 06:33:27
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