(Bloomberg) — With the U.S. Treasury borrowing heavily in the bond market, the Federal Reserve may find it has to pause its efforts to shrink its balance sheet to ensure the banking system remains stable, according to the Federal Reserve Bank of St. Louis.
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The US Treasury Department has sold about $1 trillion in securities since June after the government suspended the debt ceiling. The cash to buy that government debt can come from at least two places: bank accounts, or money market funds.
Recently, money market funds have been reluctant to buy notes, because they can often earn more by putting their money in the Fed, using the central bank’s overnight reverse repo facility, known as ON RRP.
If too much money comes from the banking system, lenders may find themselves with too few reserves to meet regulatory requirements, St. Louis Fed economists Amalia Estensoro and Kevin Klissen wrote in a research note this week. This may force the central bank to halt its quantitative tightening program, known as QT.
“There is a risk that RRP balances remain large and that bank reserves account for the majority of the contraction in Fed liabilities as QT continues,” economists Amalia Estensoro and Kevin Cleesen wrote. “In this case, banking regulatory restrictions could start enforcing sooner than expected.”
And this risk is not just academic: the decline in the Fed’s Rapid Response Plan facilities appears to have stalled. The scarcity of bank reserves has caused problems in the past, most notably in September 2019, when the Treasury increased borrowing and the Fed stopped buying as many Treasuries for its balance sheet.
At that time, overnight financing rates for Treasury securities – on which Wall Street banks widely depend – soared and the Fed eventually intervened by restarting securities purchases to add more reserves to the system.
On the other hand, if funds are drained from the ON RRP, the impact on the financial system is likely to be manageable. This seems to be the path the financial system was headed down about three months ago. After the government suspended the debt ceiling, demand for the regional bailout fell to $1.717 trillion on July 18th. But the regional bailout plan has since stabilized at levels closer to $1.8 trillion.
Wall Street strategists estimate that the Treasury Department has another $600 billion in Treasury bills to issue between now and the end of the year. This will likely not lead to the ON RRP being fully depleted in the second half of the year, according to economists.
Economists at the Federal Reserve Bank of St. Louis said that in the last round of quantitative tightening, about five years ago, it was necessary for banks’ reserves to be equal to about 7% of nominal GDP to prevent money market prices from rising. Given current GDP, this would amount to about $1.9 trillion in reserves.
But a higher level might make sense, according to economists. In the Fed’s most recent survey of chief financial officers, nearly 78% of bank representatives who responded reported that their institutions would prefer to hold additional reserves above their lowest comfortable level.
“Financial markets continue to evolve and desired liquidity may be closer to 10% to 12% of nominal GDP ($2.7 trillion to $3.3 trillion), with the current level of reserve balances already around the upper end of the estimate,” Estensoro and Klesen wrote. .
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