A Shift in Approach Could Help Keep Short-Term Markets Liquid

Since overnight lending rates in the U.S. spiked as high as 10% during trading on 17 September, steps taken by the New York Federal Reserve and the Federal Open Market Committee (FOMC) to inject excess cash into the financial system have succeeded in calming funding markets. However, the episode is a stark reminder of an unintended consequence of post-crisis regulations.

Large banks in the U.S. now operate with greater levels of capital and liquidity, which makes the system sounder, but regulations have also reduced the efficient flow of cash through the financial system and constrained the Fed’s ability to further normalize the size of its balance sheet.

While this may not matter most of the time, these frictions can create periods of elevated funding levels and episodes of stress in liquidity markets around scheduled settlement dates for U.S. Treasury issuance and important regulatory filing dates. But more importantly, a still-large balance sheet could make FOMC members warier about expanding the balance sheet during a future downturn. Instead, members might favor policies that extend the weighted average maturity of assets held, or rely more heavily on forward guidance to control the yield curve.

Still, we think there are policy tools in the Fed arsenal that wouldn’t materially alter the soundness of the banking system but could allow cash to move more freely, potentially contributing to fewer dislocations and lower systemwide liquidity needs.

Funding market stress revealed banks’ need for liquidity

Over the past several years, the U.S. Federal Reserve has been slowly normalizing the size of its balance sheet, including reducing banks’ excess reserves, as U.S. economic fundamentals improved. Until recently, that process had occurred with relatively little disruption. However, in mid-September short-term lending rates unexpectedly ratcheted higher as banks struggled to maintain adequate liquidity in the face of large corporate tax payments and other factors, which abruptly drained $100 billion–$150 billion in cash from the banking system.

In response, the Fed injected $75 billion through its temporary overnight open market operations (OMO) and subsequently announced a program to buy U.S. Treasury bills, which will inject $60 billion per month through March of 2020. Overall, we estimate these operations will increase banks’ aggregate cash reserves by roughly $300 billion–$1.5 trillion and lift the Fed’s total balance sheet to $4 trillion.

These cash infusions have succeeded in calming short-term funding markets. However, there is no guarantee the extra liquidity will always be efficiently allocated around the banking system. As a result, we expect funding market pressures to reemerge as we approach important bank reporting dates, including year-end.