MNI POLICY: Fed To Start Gradual Asset Purchases Within Months

The Federal Reserve is set to restart asset purchases as soon as money market indicators and banks' liquidity management practices show reserves have transitioned to an ample level – expected within months. But in the meantime, the central bank is encouraging banks to tap its standing repo facility during bouts of illiquidity. 

A calming in repo rates this month after several days of turbulence in October suggests the supply of cash reserves in the banking system had not yet fallen below ample. The secured overnight financing rate is now trading in line with the Fed's rate on reserve balances after jumping as high as 32 basis points above IORB on Oct 31, as the Fed announced an end to its quantitative tightening program. 

Funding pressure around special tax dates and month ends are an expected development as reserves decline, and the Fed's standing repo facility was introduced as a ceiling tool after the 2019 market ructions for precisely these episodes. It serves a wider range of counterparties than temporary open market operations, which are limited to primary dealers, and regulators emphasize no stigma is attached to its use. 

That banks borrowed just USD50 billion from the repo backstop on Oct 31 – a record take-up that was nevertheless only 10% of the facility's limit – suggests it could be used to a larger extent before the Fed needs to resume balance sheet expansion to stabilize rates. Stigma aside, if some dealers prefer preserving their relationship with their money fund lenders rather than to borrow at a better rate from the Fed, it may be another indication that funding pressures are seen as temporary.  

NOT ROCKING THE BOAT

How high funding rates rise on Dec 31 and how long they stay elevated will be a key test. 

Dallas Fed President Lorie Logan said last month there might be room for "modest further decreases in reserve supply" if temporary factors putting upward pressure on repo rates recede and rates come down relative to IORB, as they did last month. 

If they don't, gradual balance sheet expansion will be brought forward as the majority of the FOMC is keen to maintain predictability in funding markets. Dislocations in repo rates due to a true lack of liquidity could trigger an unwind of the basis trade that provides key funding to the U.S. Treasury market, the bedrock of the global financial system.

Treasury Secretary Scott Bessent and some FOMC members strongly favor a smaller balance sheet. QT over three-and-a-half years slashed USD2.2 trillion from the Fed's security holdings. The Fed will stay in the next phase of its balance sheet plan – keeping the overall size steady and allowing reserves to shrink passively as currency and other liabilities keep growing – for as long as market indicators allow.  

AMPLENESS DASHBOARD 

New York Fed President John Williams last week said that based on recent sustained repo market pressures and other signs, "it will not be long before we reach ample reserves." 

Besides vigilance on the staying power of elevated repo rates, the New York Fed markets desk monitors a suite of other reserve ampleness indicators. 

A real-time estimate of the elasticity of the fed funds rate to reserve changes is expected to become increasingly negative, reflecting the unusually quick rise in the effective fed funds rate since mid-September – 4bp over roughly five weeks – as reserves declined.

When reserves approached scarcity in 2019, the elasticity measure showed the spread between fed funds and IORB would narrow by more than 1bp if reserves increased by 1% of banks’ total assets. As of the mid-October update, the measure was statistically indistinguishable from zero.  

The Fed's dashboard of reserve ampleness indicators also includes the volume of fed funds borrowing by domestic banks, banks' postponement of outgoing payments and usage of intraday overdrafts, all of which should increase as reserves transition from abundant to ample. 

Banks wanting to economize on reserves may push out the timing of payments in the interbank market to later times in the day and borrow in the fed funds market to meet short-term liquidity needs.