New York Fed: Bank liquidity may be tighter than expected, with policy implications

Nov. 18 (Reuters) – The way the banking system manages its cash suggests that the financial system may not be as fluid as many now understand it, and that could have implications for how the Federal Reserve manages the size of its balance sheet, a paper from the Reserve Bank said. New York Fed on Friday.

That’s because even though institutions like the Federal Reserve have flooded the banking system with reserves, many banks continue to manage fast-moving cash inflows and outflows as they always have, and that’s tight. paper said. The authors argue that this method of managing monetary positions could become problematic for the Federal Reserve as it seeks to reduce the size of its bond holdings, which lowers the level of banks’ reserves in the system.

Banks view daily reserve balance levels as a “scarce resource,” the paper’s authors said, adding that “even in an era of large central bank balance sheets, rather than funding payments with ample reserve balances, we show that outgoing payments remain highly sensitive to import payments.”

“There remains the potential for strategic monetary hoarding when reserve balances are sufficiently low,” the researchers write.

“As central banks around the world respond to inflation by tightening their monetary stance and shrinking their balance sheets, the potential wholesale payment system consequences of the continued depletion of reserves by central banks is likely to be an important input in policy-making,” the paper said.

The paper, prepared by economists at the Federal Reserve Bank of New York, the Bank for International Settlements and Stanford University, comes as the Fed has been slashing the size of its massive balance sheet as part of its broader effort to tighten monetary policy to bring down the highest levels of inflation we’ve seen in 40 years.

The main part of this effort is to raise prices. But the shrinking of its balance sheet, which peaked at $9 trillion from $4.2 trillion in March 2020 when the coronavirus pandemic hit, is also key to this campaign. The Fed’s holdings are now $8.6 trillion.

Fed officials were confident that efforts to dump $95 billion a month in Treasury and mortgage securities, known as quantitative tightening, should go smoothly largely because banks still had far more cash than they needed.

Some point to the existence of more than $2 trillion a day in financial companies at the Fed through reverse repurchase agreements as evidence of this excess liquidity, which the Fed should be able to draw down effortlessly. Meanwhile, bank reserves are $3.18 trillion, down about $1 trillion from last year.

price control system

Reserve levels affect the Fed’s ability to conduct monetary policy. When reserves are in short-supply competition, it can lead to high levels of volatility in short-term market-based prices, and push them away from central bank target levels.

A shortage of reserves in September 2019 caused the Federal Reserve to intervene by borrowing and buying Treasuries to re-add reserves to the system to ensure the federal funds rate target remained at desired levels, effectively ending its first efforts at quantitative tightening.

The Fed has expressed confidence that it can draw down reserves in a way that will not affect its target interest rate. The paper suggests that the way banks manage liquidity, even when liquidity is plentiful, can challenge this view.

And although the paper doesn’t say what it means for balance sheet policy, some private forecasters are already speculating that the Fed may have to slow or halt its balance sheet contraction next year given a faster-than-expected tightening of bank reserve levels. .

One reason to expect the Fed to easily manage any type of intermittent reserve shortage is the existence of a so-called perpetual repo facility, which allows eligible banks to quickly convert Treasuries into short-term cash loans. Some want to expand this tool, arguing that it will reduce the chance of the Fed getting involved in the event of any kind of market turmoil.

(Reporting by Michael S Derby). Editing by Dan Burns

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