What Are They? And why now?
By Wolf Richter for WOLF STREET.
At its meeting on October 30-31, the Fed decided to end QT on December 1, citing tighter liquidity; and it mentioned the concept of “reserve management purchases” and their potential composition, which it said it would further discuss in future meetings, which opened the new era of post-QT.
So we’re going to hear more about “reserve balances” and “reserve management purchases” at the meeting this week, if not in the statement, then at least in the press conference; and if not voluntarily offered by Powell in his prepared remarks, then in his reply to the slew of questions from reporters about it.
Liquidity has been getting tighter after the Fed shed $2.4 trillion in securities during QT. That tightness in liquidity became apparent in September and October with turmoil in the repo market. During the years of mega-QE and still during much of QT, liquidity was sloshing in vast excesses through the system. But that is over – the turmoil in the repo market has demonstrated that.
And the minutes cited two places on the Fed’s balance sheet where this tightness in liquidity has manifested itself – both of them are liabilities on the Fed’s balance sheet.
- Reserve balances – cash that banks have put on deposit at the Fed – dropped by $1.42 trillion from the peak at the end of QE in December 2021, to $2.86 trillion now.
- Overnight reverse repos (ON RRPs) – cash that mostly money market funds put on deposit at the Fed) plunged by $2.37 trillion from the peak in September 2022 to near zero now.
Reserve balances are cash that banks have put on deposit at the Fed in their reserve accounts – sort of big checking accounts at the Fed. Banks pay each other through these accounts daily in vast sums, and they earn interest on their balances. The rate of Interest on Reserve Balances (IORB) is one of the Fed’s five policy rates, and with the October rate cut was set at 3.9%.
In normal times, reserve balances should grow with the banking system, which should grow with the economy. During QE, reserve balances ballooned far faster than the economy. During QT, reserve balances shrank even as the economy grew.
Even when the Fed holds the balance sheet steady, reserve balances continue to shrink as other liabilities grow – mainly currency in circulation and the government’s checking account (TGA) at the New York Fed, both of which are demand-based.
The Fed held the balance sheet steady in 2014 through 2017, and reserve balances fell. Then at the end of 2017, the Fed started QT-1, and reserve balances fall further.
And even after QT-1 ended in mid-2019, the Fed held the balance sheet steady, and reserve balances continued to shrink until the repo market blew out.
Reserve balances in relationship to the economy – as a percentage of GDP — shows the distortions that QE caused, and to what extent QT, and even holding the balance sheet flat, deflated those distortions in relationship to the size of the economy.
Reserve balances of $2.86 trillion have dropped to 9.2% of GDP currently, from the peak of 17.3% at the peak in Q3 2021.
ON RRPs are the other form of liquidity on the Fed’s balance sheet, which is where money market mutual funds deposit their extra cash that they don’t know what to do with. During QE, they’d exploded from zero to $2.2 trillion, and now after three years of QT, they’re back to zero.
But there were big shifts of liquidity between reserves and ON RRPs, and it is helpful to look at them as combined liquidity.
The combined liquidity (reserve balances plus ON RRPs) had peaked at $5.87 trillion in December 2021, when QE was ending. It has now plunged by $3.02 trillion, to $2.86 trillion, with ON RRPs being near zero:
Reserves and ON RRPs combined have also dropped to 9.2% of GDP, with ON RRPs at near zero, and reserves at $2.86 trillion. But the combined peak had reached 23.4% of GDP in Q4 2021, when QE ended.
Reserve balances alone don’t show to what extent the Fed’s QE had flooded the markets with excess liquidity and how much of that has been removed by now in relationship to the economy.
“Reserve management purchases” that the Fed is now talking about are similar to the classic method before 2009 with which the Fed has kept reserves and its balance sheet roughly proportional to the economy and the banking system, with total assets at around 6% of GDP.
Back then, it engaged in repos and purchased Treasury bills (mature in 1 year or less) to increase its assets and control short-term interest rates.
The chart below shows the Fed’s balance sheet from January 2023 until the bankruptcy of Lehman Brothers in September 2008. What gave total assets this jagged line were the repo transactions that varied dramatically from day to day, as the Fed attempted to actively manage short-term interest rates by adding or removing liquidity from the banking system via repos with its counterparties.
That was the old version of today’s Standing Repo Facility (SRF). In 2009, as QE flooded the system with cash, the Fed scuttled the SRF as it was no longer needed, which came to haunt the Fed in 2019, when the repo market blew out.
In early 2021, the Fed officially switched to an “ample reserves regime” (as practiced de facto since 2009), from a “scarce reserves regime” (as practiced before 2009). Under this “ample” reserves regime, reserve balances are much larger than before to make sure that there is “ample” – but not “abundant” – liquidity in the banking system.
If the Fed were to revert to a “scarce reserves regime” and minimum reserve requirements, as it did before, reserve balances could be a lot smaller than today. Since the Fed revived the SRF in 2021, which can provide daily liquidity to the banks, the Fed could back off its “ample reserves” regime.
But that won’t happen anytime soon, based on the Fed’s discussion of the “reserve management purchases,” whose explicit purpose it is to prevent reserves from becoming “scarce.”
Enjoy reading WOLF STREET and want to support it? You can donate. I appreciate it immensely. Click on the mug to find out how:
