The US banking system’s reserves, a key factor in the Federal Reserve’s decision to keep shrinking its balance sheet, tumbled below $3 trillion to the lowest since October 2020.
Bank reserves fell by about $326 billion in the week through Jan. 1 to $2.89 trillion, according to Fed data released on Thursday. That’s the largest weekly slide in over two-and—a-half years.
The decline comes as year-end dynamics force banks to pare balance-sheet intensive activities like repurchase agreement transactions in order to shore up their books for regulatory purposes. That means cash is directed to places like the central bank’s overnight reverse repo facility, draining liquidity from other liabilities on the Fed’s ledger. Balances at RRP swelled by $375 billion between Dec. 20 and Dec. 31 before falling by $234 billion on Thursday.
At the same time, the Fed has also been removing excess cash from the financial system through its quantitative tightening program, just as institutions continue to repay loans from the Bank Term Funding Program.
With US policymakers continuing QT, Wall Street strategists have been paying close attention to the lowest comfortable level of reserves — which some have estimated between $3 trillion and $3.25 trillion, including a buffer. Policymakers said at last month’s gathering it was continuing to shrink its balance sheet.
It also adjusted the offering rate on the RRP facility so that it’s in line with the bottom of the target range for the fed funds rate. That put downward pressure on short-term interest rates and some think that it could be enough to stave off reserve scarcity for a little bit longer.
Still, the debate is picking up over how much longer the Fed can keep up QT without evoking memories of September 2019. At the time, reserves had grown too scarce while the Fed was unwinding its balance sheet and a shortage led to a surge in a key lending rate and the federal funds rate. The central bank was forced to intervene to stabilize the market.
While the central bank in June lowered the cap for how much in Treasuries it will allow to mature without being reinvested, it’s unclear when the program will end altogether.
The recent reinstatement of the debt ceiling is likely going to make it more difficult for policymakers to judge that ideal level as the measures Treasury will take to remain under the cap tend to artificially add liquidity to the financial system and mask indicators of reserve scarcity. Two-thirds of respondents to the New York Fed’s Open Market Desk’s Survey of Primary Dealers and Survey of Market Participants expect QT to end in the first or second quarter of 2025.
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