Federal Reserve officials should talk about tapering their bond buying at their July meeting. Each month, the Fed buys $80 billion worth of U.S. Treasuries and $40 billion worth of mortgage-backed securities, and it reinvests all maturing principal. These purchases flood the banking system with liquidity that it cannot absorb due to regulatory restrictions, so dollars spill over into (and add pressure to) money markets. Indeed, the Fed’s money market pressure-release valve — the overnight reverse repurchase agreement facility — is letting off tremendous steam. In turn, the Fed is coming to dominate the money market in a dramatic, unprecedented and unintentional expansion that should not be undertaken by accident.
Rewind to March 2020: The Fed’s balance sheet stood at $4.2 trillion, up from $900 billion prior to the 2007-2008 financial crisis and close to its high-water mark of $4.5 trillion from January 2015. The Fed’s balance sheet now stands at $8.1 trillion, nearly double its pre-pandemic size. This increase is almost entirely due to the Fed’s bond buying, which it primarily finances with reserves — interest-paying electronic cash held by banks at the Fed. Reserve balances grew from $1.7 trillion to roughly $3.8 trillion over the same period.
Banks willingly hold substantial cash reserves to satisfy post-crisis liquidity regulations. However, other regulations also limit the size of bank balance sheets, so holding excess reserves can crowd out more lucrative banking activity. Banks may attempt to shed reserves by levying negative rates or charging fees on deposits. To avoid these losses, depositors move their dollars to money market, which take reserves off of bank balance sheets.
In turn, MMFs come under greater stress to find risk-free investments with positive returns. Because MMF shares are treated as equivalent to actual dollars, if they fall below a $1-per-share price (or “break the buck”), it could cause a run on MMFs. Like a traditional bank run, this would create financial instability. We saw it in 2008 when over 100 funds required a bailout, and the U.S. Treasury temporarily guaranteed over $3 trillion in MMF shares.
The Fed’s ON RRP facility was created in September 2013 to relieve the negative-rate pressures of liquidity overruns. An essential tool for short-term borrowing by major financial institutions, the repo “borrower” sells the “lender” a Treasury security under an agreement to repurchase it tomorrow at a fixed price. It’s effectively a loan with the Treasury security as collateral. The interest paid is the difference between the repurchase price and the sale price.
MMFs and government-sponsored enterprises can use ON RRP to lend to the Fed, soaking up the excess dollars the Fed itself creates. (Major banks can use ON RRP, too, but the facility pays less interest than reserve balances and stays on bank balance sheets.) So long as the Fed provides enough ON RRP, this liquidity won’t force MMFs to break the buck. Yet as a result, ON RRP now constitutes about half of the overnight Treasury repurchase agreement (repo) market.
On June 30, ON RRP reached $991 billion. Meanwhile, comparable private transactions tracked by the New York Fed’s Secured Overnight Financing Rate totaled only $871 billion. Prior to 2021, ON RRP usage hit a high-water mark of $475 billion in 2016. ON RRP usage substantially receded in 2018 and 2019, in part due to balance sheet shrinkage. At the 2013 meeting when policymakers established the facility, the idea of a trillion-dollar ON RRP literally got laughs. Far from laughable, it’s the predicable consequence of a bloated balance sheet. And today, bond buying continues at top speed.
Fed Chairman Jerome Powell has consistently pledged that the Fed will taper bond purchases “very gradually over time and with great transparency.” Yet according to the June Survey of Primary Dealers (a survey by the New York Fed of its own counterparties), the middle 50 percent of banks expect the Fed to purchase between $1.2 trillion and $1.6 trillion of additional bonds before the end of 2022, even if they begin tapering in January.
Consequentially, the Fed’s repo footprint would grow to dwarf the private market for Treasury repo. Together with a decline in the U.S. Treasury’s cash holdings, which are currently about $400 billion higher than usual due to the pandemic, these figures imply that ON RRP usage would reach between $2.6 trillion and $3 trillion at the end of 2022. That is, unless there’s a sudden increase in the ability of the banking system to warehouse another few trillion dollars of reserves — which might require substantial regulatory reform that key Democrats oppose.
It’s worth noting that this excess liquidity won’t simply evaporate once bond buying ends, either. Draining it would require the Fed to tremendously shrink its balance sheet. Last time around, policymakers waited three years after bond buying ended in 2014. They started shrinkage in October 2017 but called it quits in September 2019. Measured through February 2020, the Fed only managed to shrink its balance sheet by $300 billion on net. That math means: Don’t hold your breath waiting for the balance sheet to return to normal levels.
The Fed’s original balance sheet expansion killed the competitive market for overnight loans between banks. With an abundance of interest-paying reserves, banks no longer must borrow to meet their liquidity needs. Now, as these dollars spill over into money market pipes and ON RRP balloons, the competitive market for overnight repo is on a similar path to extinction. Why lend in the market when the Fed offers the best rate?
As the “banker to the banks,” Congress tasked the Fed to act as their “lender of last resort” in times of crisis. Should we now consider it the money market’s borrower of first resort? Even in times of calm? Policymakers must decide.
Christopher M. Russo is a research fellow with the Mercatus Center at George Mason University, and previously advised top policymakers at the Federal Reserve on monetary policy and sovereign debt management.
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