Fed considering tools to help flow of reserves in the system

The Federal Reserve is considering making adjustments to its operating framework that could improve the flow of reserves in the system, chairman Jerome Powell said on October 30.

The Fed is looking at reintroducing a version of intraday liquidity measures, or “daylight overdrafts”, in response to last month’s liquidity episode, Powell said during the rate decision press conference.  

In addition, the chair said, there are a few other “technical things” that the Fed is considering to allow cash to move more freely in the system.

On September 17, overnight repo rates reached extremely rare heights. Some transactions in the repo market recorded rates of over 9%, more than four times their morning levels.

Knock-on effects were seen in the federal funds rate – the Fed’s target rate – which breached the upper limit of the central bank’s target band (2.25% at the time). The rate rose to 2.3% on September 18.

The episode caught the Fed and markets off-guard, prompting an unscheduled Federal Open Market Committee meeting on October 11 to announce a new set of asset purchases.

Effective on October 15, the New York Fed began purchasing assets at an initial pace of roughly $60 billion a month, with purchases set to continue “at least into the second quarter of next year”, Powell said during the October 11 announcement.

The New York Fed has also been conducting daily and 14-day term repo auctions to provide banks with the reserves they need on a shorter-term basis. The auctions are set to continue at least until the end of January.

Lack of arbitration

The volatility in rates is thought to be due to several reasons. Until the press conference, the Fed has emphasised factors such as banks being caught short of cash during routine tax payments on September 16, and an increase in Treasury issuance, causing an outflow of reserves from the system.

On October 30, Powell publicly acknowledged a “surprising” unwillingness by some banks to use their reserves to arbitrage the higher rate, which he said had been an additional factor behind the spike in rates.

Powell said: “[Some banks] didn’t deploy that liquidity when there seemed to be great opportunities to do that.” This meant some parts of the system were unable to access liquidity, driving up rates.

On September 27, Philadelphia Fed president Patrick Harker admitted that the financial plumbing might be “rusty or clogged”. The remarks appeared to be an acknowledgement that the episode may have been caused by the failure of reserves to flow throughout the system, as much as their total level.

Over the last two years, the Fed has been conducing a reserve management survey with banks, the Senior Financial Officer Survey, to try to understand the lowest comfortable level of reserves banks are willing to hold.

“Many banks that were well above that level did not take that excess cash and invest it in the repo market at much higher rates,” Powell said. “So, the question is why, and are there adjustments we could make that would allow liquidity to flow more easily in the system without in any way sacrificing safety and soundness of financial stability?”

One concern among observers is that post-crisis capital and liquidity ratios have stood in the way of banks using excess reserves to profit form higher rates.

William Nelson, former deputy director of monetary affairs at the Fed, argues that liquidity regulations have inadvertently created a preference for banks to hold reserves over Treasuries, despite them being viewed as equal from a supervisory perspective. 

He also argues that capital requirements may stop large banks from borrowing in wholesale funding markets to arbitrage the higher repo rates.

“They would increase their systemic risk score and therefore risk getting a higher G-Sib [global systemically important banks) surcharge,” he says in a blog post. “Most of the components of the systemic risk score are calculated on a year-end basis, but the short-term wholesale funding component is based on a daily average.”

Powell said lowering capital and liquidity ratio requirements are not likely to be an adjustment the Fed will consider. “I don’t think that’s where this goes,” he said, referring to the Fed’s “forensic work” in analysing the funding episode.

The potential daylight overdraft solution – which was a common feature of the pre-crisis framework for conducting intraday payments – would enable banks to temporarily overdraw their reserve accounts during times of volatility. Beyond Powell’s brief comment, however, the Fed has not provided any further information, so it is unclear how it would work in practice.

‘The most important thing’

The chairman said the “most important” feature of the Fed’s response is to get reserves back up to a level where the volatility does not drop below a level where rates begin to spike again.

The adjustment to improving the flow of funds “can’t really address the situation in the short term”, he said.

“We think we need reserve back up the level seen before September,” Powell said. “We don’t want them to move below the level that we were at in the beginning of September, which is between $1.45 trillion and $1.5 trillion.”