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

Nov 18 (Reuters) – The way the banking system manages cash shows that the financial system is not as it is currently understood, and that could have implications for how the Federal Reserve manages the size of its balance sheet, a paper from the Federal Reserve Bank of New York said on Friday.

That’s because even though institutions like the Fed have flooded the banking system with reserves, many banks continue to manage their inflows and outflows of cash as fast as they can, and it’s tight, said the paper. The authors argue that this way of managing the cash position could be problematic for the Fed as it seeks to reduce the size of its bond holdings, which reduces the level of bank reserves in the system.

Banks see the level of their daily reserve balance as a “scarce resource,” said the author of our paper, adding “even in the era of large central bank balance sheets, instead of financing payments with large reserve balances, we show that outgoing payments are still very sensitive to incoming payments. “

“There is still potential for strategic cash hoarding when reserve balances are low enough,” the researchers wrote.

“As central banks around the world respond to inflation by tightening their monetary stance and shrinking their balance sheets, the potential consequences for the wholesale payment system of the ongoing draining of central bank reserves will likely be an important input to policy making,” said the paper.

The paper, by economists at 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 a broader effort to tighten monetary policy to lower the top rate. inflation seen in 40 years.

The main part of the business rests on rising costs. But the contraction of its balance sheet, which peaked at $9 trillion versus $4.2 trillion in March 2020 when the coronavirus pandemic struck, was also key to the campaign. Fed Holdings currently stands at $8.6 trillion.

Fed officials have believed that efforts to shed $95 billion per month in Treasury and mortgage bonds per month, known as quantitative tightening, should run smoothly in large part because banks still have far more cash than they should.

Some point to more than $ 2 trillion per day financial firms park at the Fed via the reverse repurchase agreement as evidence of this excess cash, which the Fed should be able to painlessly withdraw. Meanwhile, bank reserves stood at $3.18 trillion, down about $1 trillion from a year ago.

Speed ​​control regime

Reserve levels affect the Fed’s ability to conduct monetary policy. When reserves are in short supply competition for them can introduce a high level of volatility in short-term market-based rates, and push them far from the target level by the central bank.

The lack of reserves in September 2019 led the Fed to intervene by borrowing and buying Treasury securities to add more reserves to the system to ensure its target federal funds rate remains at the desired level, effectively ending its first attempt at quantitative tightening.

The Fed has expressed confidence that it can pull down reserves in a way that will not affect its target interest rate. The paper shows the way banks manage liquidity, even in times of great liquidity, can challenge that view.

And while the paper does not say what the balance sheet policy means, some private sector forecasters are speculating that the Fed may be forced to slow down or stop its balance sheet contraction next year in the sooner-than-expected tightness of bank reserves. .

One reason to expect the Fed to more easily manage any kind of intermittent reserve shortage is the existence of the so-called Standing Repo Facility, which allows eligible banks to quickly convert Treasuries into short-term cash loans. Some want the tool to be developed, arguing that it will reduce the chance that the Fed will need to intervene in the event of a sort of market turmoil.

Reporting by Michael S. Derby; Editing by Dan Burns

Our standards: Thomson Reuters Trust Principles.

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