Probing LCLoR

Published on May 15, 2023 by Free

Bank reserves are on track to approach a common estimate of the Lowest Comfortable Level of Reserves (“LCLoR”) within a few months. At the moment, reserves sit around $3.2t and a common Fed estimate places LCLoR at around $2.2t (8% of GDP). In addition to quantitative tightening, two events may soon reduce bank reserves to around $2.2t. First, the RRP is likely to steadily increase as MMF assets continue to rise and FHLB debt issuance declines. Second, the Treasury General Account’s eventual replenishment will likely be financed largely from reserves. The decline in reserves may only be temporary, as persistent bill issuance would eventually redirect liquidity out of the RRP and back into the banking system. This post reviews the mechanics behind the upcoming drain in suggests the Fed has only one good tool at its disposal.

Rising RRP

RRP participation is likely to steadily increase over the next few months and mechanically drain bank reserves. The rising participation would be due to increasing money market fund assets amidst declining alternative investment opportunities. In hiking cycles there is typically a lag of several months between the first hike and when yield sensitive investors begin to allocate into MMFs. MMF assets had been flat until early in the year, but now show steady weekly inflows that historical data suggests will continue. The investment opportunities for money funds will likely remain limited in the coming months, so these inflows would be directed into the RRP.

There is usually a lag of several months between the first hikes and money fund inflows.

Money funds had been investing their marginal inflows into Federal Home Loan Bank debt, which grew rapidly during the March banking panic. FHLBs are government sponsored enterprises that largely borrow from MMFs to provide cheap loans to banks. MMF holdings of Agency debt rose by $200b in the March in line with the surge in FHLB issuance. The near record high volumes of federal funds, a measure excess FHLB liquidity, suggests declining demand for FHLB loans and thus declining FHLB debt issuance. MMFs may have no choice but to reinvest maturing FHLB debt into the RRP.

Note: Agency holdings include all agencies, not just FHLBs.

Replenishing the Treasury General Account

The Treasury’s expected replenishment of the TGA account from the current $150b to around $600b is likely to significantly drain bank reserves. The replenishment could be financed out of bank reserves or the RRP, but recent history shows that MMFs are no longer marginal investors in Treasuries. The marginal investors in Treasuries appear to be households, who would finance their purchases out of funds in the banking sector. Should that persist, then the TGA replenishment will amount to a rapid drain of a few hundred billion in bank reserves.

Treasury indicates TGA targets of $550b for June and $600b for September.

In the medium-term bank reserves would eventually be replenished through persistently high bill issuance. The Treasury is indicating a sizable $1t in bills issuance over the next 6 months. The rapid increase in bill supply should eventually be enough to raise bill yields and entice some MMFs with withdraw money out of the RRP and invest in bills. Those funds would flow out of the RRP, into the TGA, and eventually enter the banking system as the Federal government makes payments. The process may be slow, but bill issuance will only continue to increase in the months beyond as the fiscal deficit is expected to be persistently large.

Treasury anticipates $1t in bill issuance over 6 months.

One Big Tool

The exact timing of the move towards LCloR would largely depend on the resolution of the debt ceiling, which sets in motion the replenishment of the TGA. The vagaries of politics will dictate the timing, but a common estimate is a resolution around July. Regardless, bank reserves are set to steadily decline due to a growing RRP and on-going QT. The $2.2t estimate of LCloR could be too conservative, but the Fed may be afraid to find out.

An unwelcome move towards LCLoR would leave the Fed without many options other than a repeat of the 2019 Reserve Management Purchases. Pushing cash out of the RRP and into banks by toggling the RRP offering rate or adjusting counterparty limits is very unlikely because it interferes with the Fed’s ability to control rates. But purchasing bills to add reserves would be effective and tailored. The Fed would not perceive this to be a change in the stance of policy because it is duration neutral, but other market participants may view it differently.

15 comments On Probing LCLoR

  • I strongly prefer having dates clearly marked on the posts.

  • Thank you for the information, something to keep an eye on!

  • Looks like the S&P ran up about 10% in the weeks following the 2019 Reserve Management Purchases announcement. I guess we better get ready for the Money-Printer-Go-Burr memes to come back on Twitter…

  • Until 2008, US banks had $46Bn in reserves (essentially what the system needed to settle overnight intra-bank liabilities).

    And now they have $3T.

    And this is a problem?

  • Paul Volcker was quoted in the WSJ in 1983 that the Fed: “as a matter of principle favors payment of interest on all reserve balances” … “on rounds of equity”. [sic]

    Interest rate manipulation as a monetary transmission mechanism is non sequitur. Interest is the price of credit. The price of money is the reciprocal of the price level.

    Using interest rate manipulation as its monetary transmission mechanism, under an ample reserves regime, the time-frame of the FOMC’s horizon is 24 hours, rather than 24 months.

    Bernanke, pg. 287, “Lower long-term rates also tend to raise asset prices, including house and stock prices, which, by making people feel wealthier, tends to stimulate consumer spending-the “wealth effect”

    Monetary policy should delimit all required reserves to balances in their District Reserve bank (IBDDs, like the ECB), and have uniform reserve ratios, for all deposits, in all banks, irrespective of size (something Nobel Laureate Dr. Milton Friedman advocated, December 16, 1959).

    Monetarism involves targeting total legal reserves and their reserve ratios. That was the true policy instrument.
    Monetarism does not mean targeting nonborrowed reserves, which as Volcker found out, was not restrictive. Volcker stopped inflation by imposing reserve requirements on NOW accounts in April 1981.

  • link: Daniel L. Thornton, Vice President and Economic Adviser: Research Division, Federal Reserve Bank of St. Louis, Working Paper Series
    “Monetary Policy: Why Money Matters and Interest Rates Don’t”
    “Today “monetary policy” should be more aptly named “interest rate policy” because policymakers pay virtually no attention to money.”

    The money supply can never be properly managed by any attempt to control the cost of credit.

    Unlike Treasury issuance, because the belligerent bifurcation (the mis-aligned distribution of sales and purchases of debt by the FRB-NY’s trading desk and its customers/counter-parties is largely unpredictable, so too now is the volume and rate of expansion in the money stock.

    FOMC policy has now been capriciously undermined by turning excess reserves into bank earning assets. Interbank demand deposits, IBDDs, were non-earning assets prior to October 2008. So, the FED has emasculated its “open market power”, the power to create new money and credit. I.e., remunerating IBDDs emasculated the money multiplier (more accurately defined as commercial bank credit divided by legal reserves).

    link: Bank Reserves and Loans: The Fed Is Pushing On A String” – Charles Hugh Smith

    This is in direct contrast to targeting: *RPDs* using non-borrowed reserves as its operating method (predating Paul Volcker’s October 6, 1979 pronouncement on the *Saturday before Columbus Day*), as Paul Meek’s (FRB-NY assistant V.P. of OMOs and Treasury issues), described in his 3rd edition of “Open Market Operations” published in 1974.

    The validity of the money multiplier (commercial bank credit expansion coefficient) as a predictive device is predicated on the assumption that the commercial banks will immediately expand credit and the money supply (invest in some type of earning asset), if they are supplied with additional excess reserves.

    The inconsequential volume of excess reserves held by the member commercial banks from 1942 until October 2008 provides documentary proof that the DFIs undoubtedly did. Today’s loan-to-deposit ratio notwithstanding.

    This adds up to an obdurate apparatus that the Fed cannot monitor, much less control, even on a month-to-month basis. The effect of current open market operations on pegging interest rates is indirect, varies widely over time, and in magnitude. What the net expansion of money will be, as a consequence of a given change in policy rates, nobody knows until long after the fact. The consequence is a delayed, remote, and approximate control over the lending and money-creating capacity of the banking system.

    As I said: “The only tool, credit control device, at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be properly controlled is legal reserves. The FED will obviously, sometime in the future, lose control of the money stock.”

  • “The rate of remuneration on bank reserves at the Fed (5.15%) is now (May 2023) substantially higher than the yield on 10-year US government securities (3.4%). ”

    This artificial interest rate inversion is restrictive. And because of “core” deposits, the banks are able to outbid the nonbanks for loan funds, inducing nonbank disintermediation.

  • Could you elaborate a bit more about why the Fed is unlikely to reduce counterparty limits on the RRP as a mechanism to channel funds out of the RRP. Would that not have the same effect on short term rates as the Fed buying bills themselves? How does it then impede with their ability to control rates?

    • The rate the Fed wants to control is the Fed Funds Rate – currently the range is between 5% – 5.25%. The IORB and RRP rates are to aid in providing a floor on the Fed Funds. If RRP rates are lowered or if counterparty limits are reduced, the result will be excess cash that need to be invested overnight, and this may cause rates falling below the 5% lower bound.

      Fed buying Tbills will result in Tbill rates declining but will not impact the Fed Funds Rate.

  • Is the current draw down of the TGA until x date offsetting QT and creating a temporary increase in bank deposits? This appears to be the case per recent H8 data, but the seasonally adjusted series makes it ambiguous as to how much of the increase in deposits is seasonality. It sounds like 2H 2023 could see a significant decrease in deposits and reserves with the TGA rebuild and QT, unless RRP drawdown offsets. Any thoughts on the magnitude of RRP drawdown this year?

  • Brian Sack:
    “So, basically the proposal is, Treasury could have some predictable regular policy for buying age securities and replacing them with newly issued securities, which tend to be more liquid.”

    Good way to start a flight from the dollar, hyperinflation, a run-in short-term liabilities and destruction of the U.S. dollar.

  • Brian Sack:
    “the floor system…is designed to achieve effective control of overnight market interest rates under a variety of outcomes for the balance sheet size. That control has been very, very strong. So, the SOFR rate, which is the benchmark repo rate, probably the most important overnight interest rate in our financial system, that has been largely pinned to the rate set on the Feds’ overnight reverse repo facility or at least within a few basis points of that facility rate. And the federal funds rate has remained remarkably stable in the center of the target range set by the FOMC.”
    The time-frame of the FED’s economic analysis is 24-hours rather than 24-months.

  • I think it’s worth revisiting your last paragraph: “An unwelcome move towards LCLoR would leave the Fed without many options other than a repeat of the 2019 Reserve Management Purchases. Pushing cash out of the RRP and into banks by toggling the RRP offering rate or adjusting counterparty limits is very unlikely because it interferes with the Fed’s ability to control rates. But purchasing bills to add reserves would be effective and tailored.”

    Wouldn’t an alternative to purchasing bills be to lower the RRP rate (slightly) while Treasury issues a lot of bills, such that the RRP money flows from the RRP into bills? That would at least neutralize the decrease in reserves from ongoing QT and could even increase reserves in the short term if QT < net issuance of treasury bills. Is my thinking on that correct? They could theoretically do this until they drain down RRP

    I would refer you to PNC's comments on the topic about 9 minutes into this presentation. Bill mentions this exact issue, but caveats that it under consideration but nothing is decided. Link:

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