The Federal Reserve on Wednesday moved to end its balance sheet runoff, or quantitative tightening, to address increasing liquidity strains across short-term funding markets.
In one respect, this decision was inevitable. Liquidity strains have grown as money-market funds drain their deposits at the Fed’s overnight repo facility. The cash is then used to purchase short-term debt issued by the Treasury to fund government operations and its growing debt. This shift has caused a drop in bank reserves.
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At the same time, Treasury policy currently favors the issuance of short-term maturities in contrast with long-dated paper that investors would almost surely charge a higher risk premium and that would drive those rates higher.
Sustained large issuance of T-bills to finance government debt and the draining of liquidity to buy those securities could lead to an unwarranted and unwelcome market dislocation. The increase in overnight rates has consequences, not only for the Fed’s market operations but also for the day-to-day cost of doing business.
The repo facility was created in the wake of the 2008-09 financial crisis as a way to inject liquidity into the money-market sector.
Money-market dealers and banks could deposit their collateral in the form of Treasury securities that were earning near-zero returns and earn the facility’s award rate.
Federal Reserve Chairman Jerome Powell has since argued that the Fed’s payment of interest to banks that park money at the Fed has become an essential tool for controlling short-term rates.
The recent drop in demand for these overnight deposits is now pressuring rates higher. That in turn affects the cost of credit for business, eventually increasing the cost of goods and pressuring inflation higher.
While the recent draining of funds from the Fed’s repo facility was expected as part of drawing down the Fed’s balance sheet, it seems evident that the Fed is concerned that the level of bank reserves has moved from abundant to merely ample, and that was a factor in ending the balance sheet reduction.
In an economy where lower rates, liquidity and leverage are part of what is driving financial markets higher, the end of quantitative tightening to address broader liquidity strains marks an important change in Fed policy.
