Fed’s Reverse Repo Facility Drawdown Casts Shadow Over Balance Sheet Debate, Says Reuters

By Michael S. Derby

In New York, the future of the Federal Reserve’s bond holding reduction efforts seems increasingly linked to the activity in the central bank’s reverse repo operations.

The reverse repo facility allows eligible banks and investment firms to deposit cash at the Fed and earn interest, serving as a significant source of liquidity that the Fed can reduce as it seeks to unwind pandemic-era stimulus measures.

Launched nearly a decade ago, this program saw a rapid increase in activity starting in the spring of 2021, peaking at over $2 trillion daily inflows by June 2022. This was seen as a clear indicator of the excess liquidity in the financial system. However, inflows have sharply decreased in recent months, now averaging around $1 trillion, largely due to the Fed’s aggressive tightening policies introduced last year.

Many central bankers and market analysts believe that once the reverse repo facility is substantially depleted, or at least reduced significantly, the overall liquidity in the financial sector will tighten enough for the Fed to consider ending or at least reassessing its ongoing bond drawdown.

In addition to reverse repos, bank reserves have remained steady between $3.0 trillion and $3.4 trillion since the Fed began its quantitative tightening (QT) efforts. The extent to which the Fed can reduce these reserves is uncertain, as banks prefer to maintain a healthy cash buffer.

Fed officials have expressed confidence that they can further reduce their holdings of Treasuries and mortgage-backed securities, correlating this with interest rate hikes. Many market analysts anticipate that the bond drawdown could conclude sometime next year.

Lorie Logan, president of the Dallas Fed, noted that reverse repos have been declining smoothly. She mentioned uncertainty regarding the timeline for this process but expressed the view that overnight reverse repos should approach zero before the Fed can fully assess the situation regarding its balance sheet.

The Fed’s current balance sheet stands around $8 trillion, down approximately $1 trillion from its peak last year. Economists at Wells Fargo project that the balance sheet runoff could conclude by the start of the third quarter next year, with holdings falling to about $7.2 trillion, largely due to an anticipated recession altering Fed policy direction.

If reverse repos continue to decline gradually while bank reserves also decrease slowly, it could push the QT end date to late 2025. Conversely, if reverse repos stabilize around $500 billion, the end could come sooner, in the second quarter of 2025, with holdings reducing to $6.5 trillion. However, should reverse repos remain around $1 trillion, a more rapid decline in reserves might prompt the Fed to slow the drawdown by next year and conclude it by the end of 2024.

The goal of QT is to ensure ample reserves for a functioning banking system while maintaining firm control over the Fed’s short-term interest rate target, currently set between 5.25% and 5.5%. During the previous QT initiative in 2019, the Fed allowed reserves to shrink excessively, leading to a spike in the federal funds rate and necessitating an intervention to restore it to the target range. New mechanisms like the Standing Repo Facility and lessons from past experiences have given central bankers confidence in avoiding such issues this time.

Despite these reassurances, identifying market signals indicating insufficient reserves could be challenging. Analysts are closely monitoring metrics like the federal funds rate approaching the upper limit of its designated range, along with changes in interest rate relationships and bank reserve management practices.

Lou Crandall, chief economist at a research firm, emphasized that Fed policymakers are acutely aware that indicators of liquidity tightness may differ from previous experiences. In his assessment, if reverse repos stabilize, it could signal sufficiently tight liquidity conditions to prompt the Fed to adjust its strategy.

Crandall believes the Fed still has time to navigate this process, a sentiment echoed by Cleveland Fed President Loretta Mester, who stated that the substantial balance sheet size allows for continued cuts over the next one and a half to two years, acknowledging that reaching the finish line will take considerable time.