The Question the Fed Did Not Answer When It Cut Rates
Wednesday’s announcement by the Federal Reserve’s Open Market Committee (FOMC) of a quarter-point cut in its policy rate was expected. What may not have been expected is the split among the 17 members of the committee on the need for more rate cuts.
Less than half (seven) of the committee members indicated that they see a need for more rate-cutting this year, while five saw no need for further cuts and five said rates should be increased. The central bank’s more immediate problem, however, appears to be a lack of liquidity in its short-term repurchase (repo) operations.
On Tuesday, the lending rate for short-term borrowing by banks soared to around 10%, more than four times the Fed’s then-2.25% ceiling. The Fed’s repo facility, which makes overnight loans out of reserves held by the New York Fed on behalf of certain financial institutions, purchased some $53 billion in Treasury notes and other assets (called repurchase agreements) from these institutions in order to maintain sufficient liquidity for their trading activity. The Fed purchased another $75 billion in assets on Wednesday and will purchase an additional $75 billion worth on Thursday.
When liquidity is constrained, the overnight interest rate can soar, as it did Tuesday. In this instance, demands for cash to finance quarterly tax payments and meet Treasury auction requirements are believed to have led to the demand for cash. The Fed’s cash infusion of around $200 billion (so far) provides the reserves needed to keep the financial system running without visible interruption to the vast majority of Americans.
The questions that remain are how long the Fed can or should continue to inject liquidity into the repo market and how the bank plans permanently to solve the cash crunch. Fed Chair Jerome Powell said on Wednesday that the bank would continue to pump cash into the repo market until such injections are no longer needed.
In his press conference, Powell said, “It is certainly possible that we’ll need to resume the organic growth of the balance sheet sooner than we thought.” That means that the Fed will purchase additional securities from banks to boost its reserves in the longer term and ensure that there is enough liquidity for the banking sector. There was some speculation ahead of the FOMC’s Wednesday announcement that the Fed also would commit to growing its balance sheet, but that didn’t happen.
One alternative to expanding the Fed’s balance sheet that has received some attention is a standing repo facility. Rather than having the Fed actively manage reserves that may climb to nearly $800 billion, the country’s large banks may settle for a way to liquidate Treasury securities if they could do so without paying too high a premium when they need short-term cash. Here’s how a standing repo facility would work, according to a blog post at the St. Louis Fed:
The Fed could easily incentivize banks to reduce their demand for reserves by operating a standing overnight repurchase (repo) facility that would permit banks to convert Treasuries to reserves on demand at an administered rate. This administered rate could be set a bit above market rates—perhaps several basis points above the top of the federal funds target range—so that the facility is not used every day, but only periodically when a bank needs liquidity or when market repo rates are elevated.
With this facility in place, banks should feel comfortable holding Treasuries to help accommodate stress scenarios instead of reserves. The demand for reserves would decline substantially as a result. Ample reserves—and therefore the size of the Fed’s balance sheet—could in fact be much closer to their historical levels.
Those “historical levels” are closer to $20 billion than $800 billion.
Bloomberg cites Jon Hill of BMO Capital Markets on what the Fed did Wednesday:
Though they didn’t announce a standing repo facility, what they did in essence is set up a “sitting” one that can stand up when it needs to. The market now knows the Fed will come in during stress conditions. So this will kind of operate in the pressure-valve way that was so needed.