(Bloomberg) — The US banking system’s reserves, a key factor in the Federal Reserve’s decision to keep shrinking its balance sheet, sank below $3 trillion once again, just as Chair Jerome Powell signaled quantitative tightening could stop in the coming months.
Bank reserves fell by about $45.7 billion to $2.99 trillion in the week through Oct. 15, according to Fed data released on Thursday. That nearly reversed the prior week’s increase of $54.3 billion.
The drop comes as the Treasury has ramped up debt issuance to rebuild its cash balance following the increase in the debt ceiling in July. That drains liquidity from other liabilities on the Fed’s ledger, like the central bank’s overnight reverse repurchase agreement facility and bank reserves.
But with the so-called RRP nearly empty, commercial bank reserves parked with the Fed have been dropping. Cash assets held by foreign banks have declined at an even faster pace than those by their US counterparts.
The shifts in cash affect the day-to-day operations in the financial system as the Fed continues unwinding its balance sheet, a process known as quantitative tightening or QT. As QT may exacerbate liquidity constraints and lead to market turbulence, the Fed earlier this year slowed the pace by reducing the amount of bond holdings it lets roll off every month.
Powell said Tuesday that the balance sheet runoff will stop when bank reserves are somewhat above the level policymakers judge to be consistent with “ample” — the minimum required to prevent market disruptions. In the strongest signal the Fed now considers that level to be close, he said the central bank may approach that point “in coming months.”
Governor Christopher Waller said Thursday at an event the balance sheet is back to where it should be for ample. In July Waller estimated the lowest level to be somewhere around $2.7 trillion.
“We run ample reserves to ensure there’s sufficient liquidity in the banking system, in financial markets to make sure that people don’t have to, at the end of the day, go scrambling around looking for nickels and dimes in the couch to cover their reserve positions,” Waller said. “That, to me, is idiocy.”
Because of these changes in liquidity, the effective federal funds rate — the central bank’s policy target — edged higher last week within the range for the second time in more than two weeks, an indication of tighter financial conditions ahead. It remains inside the Federal Open Market Committee’s 4% to 4.25% band, set last month when policymakers cut borrowing costs. For the past two years, the metric has been stuck near the lower end of the range. This week the 75th percentile increased to 4.12% from 4.10%, which suggests that another increase in the median rate is likely to follow, according to Deutsche Bank.
Once a robust avenue for overnight interbank lending, the fed funds market used to signal when financing conditions were tightening. But massive monetary stimulus during the financial crisis and the pandemic left the country’s banking system awash in dollars, leading banks to largely withdraw from the fed funds market and park their money directly at the Fed instead.
Transactions underlying the fed funds rate have declined since there’s less surplus money for non-US institutions to deploy in the market, and the Federal Home Loan Banks — the largest set of lenders in the market — are shifting more cash to the repo market because of the higher rates.
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