personal views of a former fed trader

The Reserve Gap

A rapid decline in the level of bank reserves would be an obstacle to QT that may prompt action from the authorities. An aggressive QT was premised on first draining the large RRP balances, but the monetary plumbing suggested that was never likely. Banks can easily maintain their own reserve levels, but their own target levels are significantly below those of the Fed. This implies that bank reserve levels will likely fall below the Fed’s comfort level far before QT is slated to end. In this post we sketch out the Fed’s dilemma, show why its options are limited, and suggest that Treasury buybacks or SLR adjustments would likely be used to boost bank reserve levels.

The Bad Scenarios

The path QT takes is beyond the Fed’s control and cannot be predicted in advance. The Fed seeks to shrink its balance sheet while also keeping bank reserve levels above ~$2t (8% GDP), a level it perceives as necessary for the financial system to function. In theory, this could be achieved by QT draining the $2t held in the RRP rather than liquidity held in the banking sector. However, the Fed controls only the total quantity of liquidity drained and not where it is drained from. This opens up the possibility of bank reserve levels dropping beneath the Fed’s target before QT is slated to end.

Fed estimated minimum reserve levels with 2019 levels as a reference – ~8% GDP.

In a worst case scenario, bank reserve levels would rapidly decline from QT and a rising RRP. This could occur if incremental Treasury issuance is purchased by cash investors rather than levered investors financing purchases in repo. Repo financing would drain funds held in the RRP, while cash financing would drain funds held in the banking sector (see here). Independent of QT, higher RRP participation would also further drain bank reserves. The RRP could increase as investors move money out of banks and into money market funds due to risk aversion or the attractiveness of a high RRP rate. An unlucky confluence of the above factors could take quickly bank reserve levels from the current $3t level to the Fed’s $2t minimum.

The Gap

The banking system can easily maintain its own reserve levels, but its perceived reserve needs are much lower than those estimated by the Fed. Estimates based on surveys to banks in 2018 suggest a minimum system wide level of around $900b, which would scale to ~$1t today. Any bank can easily increase its own reserve levels by simply issuing liabilities or selling assets, but they would do so for those own needs and not those of the Fed.

Fed estimates based on survey data suggested the banking system’s Lowest Comfortable Level of Reserves (“LCLoR”) to be $900b reserves in 2018.

The Fed’s own higher minimum reserve level estimates is colored by the repo spike in September 2019, which was attributed to a lack of reserves. At that time, banks had hundreds of billions of extra reserves and invested them in repo to earn returns higher than interest on reserves. As QT reduced the extra reserve holdings of banks, it also reduced their repo lending. Repo borrowers dependent on that lending were in distress, but the the banks themselves still had far more reserves than they needed (see here).  

Red line: Fed’s estimate of needed reserves. Green line: Bank’s estimate of needed reserves

The gap between perceived and actual reserve needs means the Fed will have to find ways to top up banking system reserves. The Fed directly added reserves in 2019 by purchasing bills, but purchases today would present a significant communications challenge in the context of QT. Enticing banks to hold more reserves by raising the interest on reserves is unlikely to be effective as balance sheet space remains costly, and is likely better deployed on meeting strong loan demand. The Fed’s most reliable option would be to push investors out of the RRP by placing a binding cap on RRP participation. That would also immediately place downward pressure on all money market rates and slightly weaken the transmission of policy.

Team Effort

The best way to boost bank reserve levels may be not from Fed actions but from the Treasury and bank regulators. Treasury buybacks funded with bill issuance would move liquidity out of the RRP and into the banking sector. Money market funds would withdraw money out of the RRP to purchase the newly issued bills, and the Treasury would spend the proceeds from the issuance on purchases of coupon securities. The sellers of those coupon securities would deposit the proceeds in their bank, thus increasing bank reserve levels (see here).

Bank reserve levels could also be boosted by excluding reserves from the supplementary leverage ratio (“SLR”). The SLR imposes regulatory costs on a bank based on the size of its assets, so it disincentivizes the holding of low yielding assets like reserves. Excluding reserves from the SLR would significantly reduce the regulatory costs of holding reserves, and thus encourage higher reserve holdings. Note that modifying the SLR would be a joint decision by the Fed, FDIC, and OCC.

Easing to Tighten

QT will likely not be derailed from low bank reserve levels because the authorities have many tools to manage the situation. They could deploy Treasury buybacks or modify the SLR, both of which have already been whispered. In a worst case scenario, the Fed could place a binding cap on RRP participation. These tools also have the side effect of loosening financial conditions: Treasury buybacks reduce market duration, SLR modifications increase the banking sector’s lending capacity, and capping the RRP lowers money market rates. The easing effects may even overwhelm the tightening impact of a marginally longer QT.

24 Comments

  1. Luis

    “The sellers of those coupon securities would deposit the proceeds in their bank, thus increasing bank reserve levels“
    Why not reinvested in MM funds if rates are more attractive?

    • Joseph Wang

      They could, but the first order effect is them receiving deposits in their bank account from their sales.

    • Spencer Bradley Hall

      Savings flowing thru the NBFIs never leave the payment’s system.

  2. Kevin Muir

    Hi Joseph – great article

    Quick question: wouldn’t the Fed ultimately want the RRP program balance much lower? Wouldn’t that actually be a goal? And you could place caps (limiting supply), but couldn’t you also change the price? Wouldn’t lowering the rate encourage movement out of the RRP?

    Thanks, Kevin Muir

    • Joseph Wang

      Good question. Yes – they want the RRP balance lower. I don’t think they would lower the RRP offering rate because 1) money market rates trade in reference to the RRP rate, so lowering the RRP just shifts the constellation of rates lower. investors in RRP wouldn’t leave because the alternatives also shifted lower. 2) RRP is a floor for the federal funds rate, which must stay within the Fed’s target range. This means the lowest the RRP rate could go is the lower bound of the Fed’s target range (2.25 to 2.5% today).

      • Steve

        Give this, how will the Fed transmit interest rate decisions if the RRP is drained? Reinstate reserve requirements?

        • Steve

          …assuming QE is fully unwound.

          • Spencer Bradley Hall

            The Keynesian economists (including Friedman) at the FED think banks are intermediaries, therefore they think legal reserves are a tax [sic]

  3. Steve

    Great article as always! A question – you say “ The banking system can easily maintain its own reserve levels” but surely the overall level of reserves is set by the Fed, i.e. if one bank increases reserves another is forced to reduce them?

  4. Scott Skyrm

    Great stuff. You have a better understanding of this stuff than any bank economist! One question: How easily can a bank take excess reserves back from the Fed? Can they notify the Fed of a withdrawal and receive the funds back immediately? or does it take an hour or a day?

    • Joseph Wang

      Reserves on deposit at the Fed are instant 0 day liquidity. They can be used as long as Fedwire is open (it’s open 9pm to 7pm). If a bank does not have enough reserves and would like to top it up, it just has to go to the market and borrow. For example, it could issue CDs that would ultimately be settled as reserves. At the end of the day, it would have say $100 in CD liabilities balanced by $100 in reserves at the Fed.

      • Justin

        You mention treasury buybacks shorten duration of treasuries in circulation, but doesn’t the heavily inverted yield curve suggest that the market is hungry for duration? Not only that, the treasury would be buying back low yielding securities to issue higher yielding securities and put the US on an even less sustainable debt path as rates continue to rise? Unless I’m wrong and we are going back into a low/zero rate world soon?

  5. Mario

    Hi, Joseph.
    Great post, as always. When do you think the buyback will be executed (if it is)?
    Thanks in advance.

  6. Spencer Bradley Hall

    The FED doesn’t know a credit from a debit, money from liquid assets, a bank from a nonbank.

    “When deposits are removed from the banks, the banks have less money to lend and liquidity dries up.”
    From the St. Louis FED – “Liquidity Dries Up”

  7. Mark

    Thought provoking as usual. One thing I struggle with is why the fed feels the LCLOR is twice the amount banks say they need. If they are looking at the 2019 repo spike as justification for keeping levels above 2T as the article suggests, I would have two questions:

    1.) if banks still felt they had excess reserves even after some initial QT, why did they feel the need to pull back on repo lending?

    2.) given bank’s seemed comfortable with their reserve levels, what other part of the system has developed a reliance on the excess liquidity? It’s often theorized that hedge funds in repo leveraged carry trades may be where the extra demand came from. If that is the case, why should the fed continue subsidizing that trade?

  8. Tony

    The current mismatch between the plentitude of Cash and the scarcity of T bill collateral has it roots in Sec. Yellen’s decision to:
    a.) Spend down the $1.6 trillion that Mnuchin left in the TGA
    b.) No longer auction many of the Cash Management Bills that Mnuchin used to auction
    c.) Increase the size of the notes auctions particularly like the Treasury was doing an Operation Twist variant.

    Obvious this cash was created for and by stimulus money but that’s another story.

    To auction 2 trillion more T bills and buying back notes essentially reverses what Yellen did in the first year of the Biden presidency.

    Wouldn’t that look like that she made a mistake?

    Just asking.

    • Spencer Bradley Hall

      Yes, Yellen screwed up. Her first uptick in administered rates coincided with the deceleration in monetary flows, the volume and velocity of money. The biggest mistake in the dismal science is that banks are intermediaries, the Gurley-Shaw thesis.

      In “The General Theory of Employment, Interest and Money”, pg. 81 (New York: Harcourt, Brace and Co.): John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution (non-bank), serving to join the saver with the borrower when he states that it is an:

      “optical illusion” to assume that “a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

      In almost every instance in which Keynes wrote the term “bank” in his General Theory, it is necessary to substitute the term non-bank in order to make Keynes’ statement correct.

      • Spencer Bradley Hall

        How much are tax receipts? “In the past the Treasury did impact the money stock figure by allowing commercial banks to hold Treasury funds in Treasury Tax and Loan accounts, but since January 3, 2012, funds in these accounts must be transferred to the Fed by the close of business on the day they are received so the end-of-day balance is always zero”

        See: https://scottgrannis.blogspot.com/2022/08/tax-revenues-are-on-moon-why-double-irs.html

  9. Spencer Bradley Hall

    https://medium.com/new-york-fed/the-how-and-when-of-the-feds-balance-sheet-runoff-3c37787fa948

    “Changes in the Consumer Price Index result in adjustments to the inflation compensation amount on a regular basis. Purchases and maturities of TIPS also result in adjustments to the amount of inflation compensation reported.”

    • Anonymous

      2yr TIPS with a positive real yield of 1.3% seem like a good deal no? Inflation will likely stay sticky until ESG policies are reversed – and there are no signs of that happening. So energy driven inflation will be with us. That flows into everything – food, transporttion, heating/cooling, chemicals etc etc. After all we are a hydrocarbon consuming species – if you had to define the human species in one sentence.
      And skilled labor is also in short supply – and labor is negotiating itself a bigger piece of the pie.

    • Anonymous

      As far as the effect of QT on TIPS , it seems to me the maturing of TIPS would not affect the price of the outstanding TIPS . Ofcourse if the US issues more TIPS that would hit the price – but if I were in the US’s shoes I would’nt be issuing new TIPS – with the propects for stick inflation that could go on for years. Better to replace the maturing TIPS with nominal notes it seems to me.

  10. Spencer Bradley Hall

    The rate-of-change in bank credit has begun to decelerate.
    Bank Credit, All Commercial Banks (TOTBKCR) | FRED | St. Louis Fed (stlouisfed.org)

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