As the US Treasury borrows heavily in the bills market, the Federal Reserve may find it has to pause its efforts to shrink its balance sheet to ensure the banking system remains stable, according to the St. Louis Fed.
(Bloomberg) — As the US Treasury borrows heavily in the bills market, the Federal Reserve may find it has to pause its efforts to shrink its balance sheet to ensure the banking system remains stable, according to the St. Louis Fed.
The US Treasury has sold about $1 trillion of bills since June after the government suspended the debt ceiling. The cash to buy this government debt can come from at least two places instead: bank accounts, or money market funds.
Recently money market funds have been holding back on buying the bills, because they can often earn more by just parking their money at the Fed, using the central bank’s overnight reverse repurchase facility, known as ON RRP.
If too much money instead comes from the banking system, lenders could find themselves with too few reserves to meet regulatory requirements, Federal Reserve Bank of St. Louis economists Amalia Estenssoro and Kevin Kliesen wrote in a research note this week. That could force the central bank to halt its quantitative tightening program, known as QT.
“There is a risk that ON RRP balances remain sizable and bank reserves represent the majority of the contraction of Fed liabilities as QT continues,” economists Amalia Estenssoro and Kevin Kliesen wrote. “In this case, regulatory banking constraints could start binding sooner than expected.”
That risk isn’t just academic: the decline in the Fed’s ON RRP facilities seems to have stalled. And bank reserve scarcity has caused problems in the past, most notably in September 2019, when the Treasury increased borrowing and the Fed stopped buying as many Treasuries for its balance sheet.
Overnight financing rates for Treasury securities — widely relied upon by Wall Street banks — spiked then, and the Fed ultimately intervened by re-starting purchases of the securities to add more reserves to the system.
On the other hand, if money drains out of ON RRP, the impact on the financial system will probably be manageable. That seemed to be the path the financial system was heading down almost three months ago. After the government suspended the debt ceiling, demand for the ON RRP dropped as low as $1.717 trillion on July 18. But the ON RRP has since stabilized at levels closer to $1.8 trillion.
Wall Street strategists estimate the Treasury has another $600 billion of T-bills to issue between now and the end of the year. That probably won’t fully deplete the ON RRP in the second half of the year, according to the economists.
The St. Louis Fed economists said that in the last bout of quantitative tightening, about five years ago, bank reserves needed to be equal to about 7% of nominal gross domestic product to prevent money market rates from spiking. Given current GDP, that would amount to about $1.9 trillion of reserves.
But a higher level might make sense, according to the economists. In the Fed’s most recent survey of senior financial officers, roughly 78% of bank representatives who responded reported that their institution prefers to hold additional reserves above their lowest comfortable level.
“Financial markets keep evolving and desired liquidity may be something closer to 10% to 12% of nominal GDP ($2.7 trillion to $3.3 trillion), with the current level of reserve balances already around the upper bound of the estimate,” Estenssoro and Kliesen wrote.
More stories like this are available on bloomberg.com
©2023 Bloomberg L.P.