The Federal Reserve recently announced that it intends to purchase $40 billion in Treasury bills through April to address seasonal and tax-related demand that is equal to roughly 0.6% of the Fed’s balance sheet. It will be a 7.5% increase on an annualized basis.
While some called this a resumption of quantitative easing, or the purchase of securities to inject liquidity into the financial system, it is most definitely not.
The composition of the purchases will offset large increases in nonreserve liabilities associated with tax season.
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In addition, after April the pace of purchases will slow back to somewhere near 4.5% of the Fed’s balance sheet on an annualized basis, or roughly the level where we think nominal GDP will expand.
Given that the central bank has to make policy for a resilient and dynamic $30 trillion beast that is the American economy, the Fed’s need to manage a large balance sheet comprised of Treasury securities and mortgage-backed securities is a fact of life.
Those who wish to return to the way things were before the financial crisis, before the Fed expanded its balance sheet, are living in a fantasy world.
State of play
From time to time, often because of seasonal issues like those early in the year, the Federal Reserve’s repo facility will be drained, causing concern about the level of reserves in the banking system.
The Fed quickly responds by purchasing Treasury bills and injecting liquidity back into the system.
This year, money market funds, which include large U.S. banks, withdrew funds that had been parked at the Fed’s overnight facility since 2021 so they could purchase Treasury bills.
This move makes perfect sense; T-bills are paying similar returns to the Fed’s overnight securities, either at the repo facility or in interest on reserves, but with longer maturities and with a similar guarantee of payment.
But the nearly complete draining of the repo facility set off an alarm, signaling a drop in bank reserves that would be needed in case of a catastrophic event (as during the financial crisis era).
In addition, disruptions to the level of private overnight rates compared with the official federal funds rate makes it difficult to transmit a sustained monetary policy to the financial system and the economy.
To that point, the Federal Reserve Bank of New York has devised a measure, the slope of which represents the elasticity of the federal funds policy rate to shocks in the supply of reserves.
It shows how many basis points the spread between the funds rate and the interest rate on reserve balances (IROB) rates would move for an increase in aggregate reserves equal to one percent of banks’ total assets.
When the elasticity is positive, that signifies an abundant level of reserves. Values close to zero represent periods of ample reserves. Negative rates signify a shortage of reserves to whatever degree.
As we show, the Fed’s recent purchase of T-bills has injected liquidity into the money markets, which we attribute to moving the needle on reserve levels from ample to abundant.
The takeaway
Notions of the appropriate level of banking-system reserves have changed over time, with lending from nonbanks now playing an important role in what has become a global financial system.
Still, it is the Fed’s responsibility to adapt to the new environment to transmit its monetary policy from the official rate to the reactive overnight rates in the private sector and to the longer-term interest rates of the investment community.
The infusion of cash into the banking system from the Fed’s purchase of Treasury bills appears to have generated an abundant supply of bank reserves.
