Overabundant liquidity in the US financial system puts pressure on the Fed’s key rate

The Federal Reserve may need to recalibrate its policy toolbox, analysts say, as a glut of liquidity in the U.S. financial system has made it more difficult for the central bank to maintain tight control over its policy rate.

Short-term interest rates have fallen to historically low levels since the start of this year as cash-strapped financial institutions compete to lend it in very low-risk vehicles, such as corporate bonds. US state maturing in the near future or the so-called repurchase agreements.

“It is clear that there is a huge, insatiable demand. . . and it’s like a game of musical chairs in terms of who can find the supply first, ”said Teresa Ho, strategist at JPMorgan, who estimates there is a $ 751 billion supply-demand gap on financing markets in April.

The increase in liquidity stems in part from the Fed’s asset purchase program where it buys back $ 120 billion in U.S. government debt each month. Bank deposits shifted to money market funds along with plans by the Treasury Department to dip into its record cash reserve and disburse funds associated with the recent stimulus package passed by Congress have also increased reserve balances.

At the same time, the ministry reduced its issuance of treasury bills, which mature in a year or less, reducing the supply of a key asset used to store money.

Large amounts of money are being returned to the Fed, demand for the central bank’s reverse repurchase facility – which gives financial firms a place to temporarily park it – is exploding. Daily use last week hit its highest level since 2017, reaching $ 369 billion on Friday.

A billion dollar line graph showing that the liquidity glut is driving demand for the Fed's repo facility

These factors pushed the Fed’s benchmark interest rate to a level that has started to gain more attention from analysts and investors.

The federal funds rate hovers at 0.06%, well below the middle of the 0 to 0.25% rate targeted by the central bank. A sustained tick below 0.05% could be enough to spur the Fed to act, said Kelcie Gerson, strategist at Morgan Stanley.

The Fed already has extended access the reverse repurchase agreement program and limits lifted on the amount of liquidity, financial companies can park at the central bank between 30 and 80 billion dollars in order to drain the liquidity of the system and to slow down the downward drift of short-term rates.

A next step could be to increase the interest the Fed pays banks on the reserves they hold at the central bank, analysts say. Another is to increase the rate the Fed pays in its reverse repurchase program.

“The Fed is vigilant on this issue,” added Thomas Simons, economist at Jefferies. “They don’t want this to get out of hand.”

Source link

Don F. Davis

Leave a Reply

Your email address will not be published.