NY Fed: Bank liquidity may be tighter than thought, with policy implications

Nov 18 (Reuters) – The way the banking system manages its cash suggests the financial system may not be as good as many now understand, and that could have implications for how the Federal Reserve manages the size of its balance sheet, a paper says of the The Federal Reserve Bank of New York said this on Friday.

That’s because while institutions like the Fed have flooded the banking system with reserves, many banks continue to manage rapidly changing cash inflows and outflows as they always have, and that’s tight, the paper said. The authors argue that this way of managing cash positions could become a problem for the Fed as it tries to reduce the size of its bond holdings, decreasing the level of bank reserves in the system.

Banks view their daily reserve balance levels as “scarce resource,” the paper’s authors said, adding “even in the age of large central bank balance sheets, instead of funding payments with abundant reserve balances, we show that outgoing payments remain highly sensitive to incoming payments.”

“There is still a potential for strategic cash 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 impact on the wholesale payments system of central bank’s continued depletion of reserves is likely to be a major contributor to policy making,” the statement said. paper said.

The paper, compiled by economists from the New York Fed, the Bank for International Settlements and Stanford University, comes as the Fed has trimmed the size of its massive balance sheet as part of its broader effort to tighten monetary policy to ease the economy. highest levels of inflation seen in 40 years.

Most of that effort rests on rate hikes. But the balance sheet contraction, which peaked at $9 trillion versus $4.2 trillion in March 2020 as the coronavirus pandemic hit, is also key to that campaign. Fed holdings now stand at $8.6 trillion.

Fed officials are confident that the effort to get rid of $95 billion a month in Treasury and mortgage bonds, known as quantitative tightening, will go smoothly in large part because banks still have far more cash than they need to have.

Some point to more than $2 trillion a day that financial firms park at the Fed through reverse repurchase agreements as evidence of this excess cash, which the Fed should be able to painlessly withdraw. Meanwhile, bank reserves total $3.18 trillion, about $1 trillion less than 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 cause high levels of volatility in market-based short-term interest rates and push them well away from the levels targeted by the central bank.

A shortage of reserves in September 2019 caused the Fed to step in by borrowing and buying Treasury bills to add reserves back into the system to ensure that the Federal Funds rate target remained at the desired level, thus in fact, its first attempt at quantitative tightening came to an end.

The Fed has expressed confidence that it can tap reserves in a way that does not affect its interest rate target. The paper suggests that the way banks manage liquidity, even in a time of ample liquidity, could challenge that view.

And while the paper doesn’t say what it means for balance sheet policy, some private sector forecasters are already speculating that the Fed may be forced to slow or halt balance sheet contraction next year because of an earlier-than-expected tightness in the balance sheet. the level of bank reserves. .

One reason to expect the Fed to cope more easily with an intermittent shortage of reserves is the existence of its so-called Standing Repo Facility, which allows eligible banks to quickly convert Treasury bills into short-term borrowings. Some want that tool expanded, arguing that it would reduce the likelihood that the Fed would have to intervene in the event of any kind of market turbulence.

Reporting by Michael S. Derby; Edited by Dan Burns

Our Standards: The Thomson Reuters Principles of Trust.

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