Nov 18 (Reuters) – The way the banking system manages its cash suggests the financial system may not be as bountiful as many now believe, and that could have implications for how the Federal Reserve manages the size of its balance sheet, a document from the Federal Reserve Bank of New York announced on Friday.
Indeed, even though institutions like the Fed have flooded the banking system with reserves, many banks continue to manage rapid inflows and outflows of liquidity as they always have, and that’s tightly, according to the paper. The authors argue that this way of managing cash positions could become a problem for the Fed as it seeks to reduce the size of its bond holdings, which reduces the level of bank reserves in the system.
Banks view their 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 reserve balances abundant, we show that outgoing payments remain very sensitive to incoming flows.
“There is always potential for strategic hoarding when reserve balances get low enough,” the researchers wrote.
“As central banks around the world respond to inflation by tightening monetary policy and shrinking their balance sheets, the potential implications for the wholesale payments system of continued depletion of reserves by central banks will likely be a contributing factor. important to policy-making,” the paper said.
The paper, written by economists from the New York Fed, the Bank for International Settlements and Stanford University, comes as the Fed has reduced 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 seen in 40 years.
Most of this effort is based on rate hikes. But the contraction 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 now stand at $8.6 trillion.
Fed officials are confident that the effort to cut $95 billion per month in Treasuries and mortgage bonds per month, known as quantitative tightening, should go smoothly, largely because banks still have a lot more liquidity than they need.
Some point to more than $2 trillion a day from financial firms parking with the Fed via reverse repurchase agreements as evidence of this excess liquidity, which the Fed should be able to withdraw painlessly. Meanwhile, bank reserves stand at $3.18 trillion, down about $1 trillion from a year ago.
RATE CONTROL REGIME
Reserve levels affect the Fed’s ability to conduct monetary policy. When reserves are scarce, competition for them can introduce high levels of volatility into short-term market-based rates and drive them away from central bank target levels.
A shortage of reserves in September 2019 caused the Fed to intervene by borrowing and buying Treasuries to add reserves to the system to ensure that its federal funds rate target remains at desired levels, ending its first quantitative tightening effort.
The Fed has expressed confidence that it can dip into its reserves in a way that will not affect its interest rate target. The paper suggests that the way banks manage liquidity, even in times of abundant liquidity, could challenge this view.
And while the paper doesn’t say what that means for balance sheet policy, some private-sector forecasters are already speculating that the Fed could be forced to slow or stop shrinking its balance sheet next year due to an earlier than expected tightening of bank reserve levels. .
One of the reasons to expect the Fed to more easily manage any sort of intermittent reserve shortage is the existence of its so-called permanent repo facility, which allows eligible banks to quickly convert bonds from the Treasury in short-term cash loans. Some want this tool expanded, arguing that it would reduce the risk that the Fed will need to intervene in the event of market turbulence.
Reporting by Michael S. Derby; Editing by Dan Burns
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