MNI POLICY: Fed Resists Pressure To Retool QT, Reverse Repo

The Federal Reserve sees little need to adjust the terms of its balance sheet reduction plan or its USD2.3 trillion overnight reverse repurchase facility, despite criticism that its 4.8% yield drains deposits from banks and hastens a return to reserve scarcity.

Hundreds of billions of dollars of bank deposits have poured into money market mutual funds since March in search of higher returns and safety from banking turmoil. The ON RRP facility is used daily by 40% of money market fund investments, and some argue rising take-up poses a financial stability risk at a time when regional banks are still trying to stanch an outflow of deposits.

Stubbornly high usage of ON RRP also means QT is draining bank reserves at a faster-than-expected clip ahead of a potential U.S. default as the deadline for the debt ceiling looms, reigniting fears the Treasury market could seize up as it did in 2019, or worse. Reserve balances shrank just over USD1 trillion last year to around USD3 trillion before the collapse of Silicon Valley Bank prompted emergency lending actions that re-expanded the balance sheet. Reserves are projected to bottom out in 2026 at a minimally efficient USD2.4 trillion shortly after QT concludes.

But the Fed views ON RRP as serving its intended purpose and expects it to eventually shrink naturally as banks raise deposit rates and supply of other short-term investments such as Treasury bills increases.

NOT STICKY

Pre-pandemic norms for ON RRP take-up hovered just above USD100 billion daily and the Fed is betting usage will descend again to very low levels before QT concludes, notwithstanding debt ceiling bumpiness along the way.

A spike in Federal Home Loan Bank debt issuance at higher rates than ON RRP during the banking stress did see money market funds reallocate away from the facility. Online banks issuing discount notes above market rates last month also enticed funds away from the Fed.

Before the bank crisis, New York Fed President John Williams told reporters Fed staff are "seeing price sensitivity" on ON RRP usage. "When repo rates move up, people move out of ON RRP and go after the higher market rate. As we continue to shrink our balance sheet, we’ll see repricing in the financial system, banks are going to raise deposit rates and we’ll see repo rates adjust. It’s a process that’s going to take time. I’m not so worried about reserves coming down and ON RRP staying where it is," he said in January.

LESS ATTRACTIVE RATE?

Cutting the ON RRP rate or tightening per-counterparty caps to reduce take-up would risk dragging down the fed funds rate and send problematic signals to investors at a time when the Fed is aiming to tighten financial conditions.

"If they lower the RRP rate, there's a good chance the fed funds rate will fall toward the bottom of target band," said Dominique Dwor-Frecaut, a former IMF, World Bank and New York Fed markets desk staffer, now macro strategist at Macro Hive. "If the Fed allows the fed funds rate to move lower In the band, there could be a big signaling impact. Would markets read it as a sign that the Fed is becoming dovish? That could lead to an easing of financial conditions and in general complicate communications."

A simultaneous upward adjustment of the interest on reserve balances to offset that effect would be expensive for taxpayers and discourage bank competition for funds. IORB is currently set at 4.9%. The two administered rates together prevent the fed funds rate from falling below the bottom of the target range.

NEW PLUMBING

As time makes clear how the collapse of SVB reshapes the banking system, the Fed may need to reevaluate the financial system's demand for reserves.

In a world in which lawmakers must raise deposit insurance limits to stabilize the system and investors increasingly move assets outside banks, the Fed will have to reexamine whether markets can function without more collateral, among other issues, said University of Chicago economist Anil Kashyap, who consults for the Chicago Fed and European Central Bank.

"It wouldn't surprise me if they rewire some of the financial system, with less of it going through some set of banks and more through markets. In that case, the size of the balance sheet might look different," he said in an interview.