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

By Michael S. Derby

(Reuters) – The way the banking system manages cash suggests that the financial system may not be as ample as many now understand, which could have implications for A document from the New York Fed said on Friday how the central bank manages the size of its balance sheet. Many banks continued to manage fast-moving cash inflows and outflows as usual, and strictly, the newspaper said. The authors argue that this way of managing the cash position could become a problem for the Fed as it attempts to reduce the size of its bond holdings, thereby reducing the level of bank reserves in the system.

Banks view their daily reserve balance levels as a “scarce resource,” the paper’s authors said, adding that “even in an era of large central bank balance sheets, we do not Funding payments with ample reserve balances suggests that payments remain highly sensitive to collections.”

“When reserve balances are low enough, strategic cash hoarding remains possible,” the researchers wrote.

“As central banks around the world respond to inflation by tightening monetary stances and shrinking balance sheets, the potential consequences for central banks of continued depletion of reserves on wholesale payment systems could become an important input to policymaking,” The newspaper said.

The paper by economists from the New York Fed, the Bank for International Settlements and Stanford University comes as the Fed has been reducing the size of its massive balance sheet as part of a broader effort to tighten Monetary policy to reduce the highest level of inflation in 40 years.

A major part of this effort will be raising interest rates. But the shrinking of its balance sheet, which peaked at $9 trillion in March from $4.2 trillion when the coronavirus pandemic hit, is also key to the movement. The Fed currently holds $8.6 trillion in assets.

Fed officials believe the effort to cut 40 billions of dollars in Treasury and mortgage bonds a month, known as quantitative tightening, should go well. Largely because banks still have far more cash than they need.

It has been pointed to the fact that over $2 trillion is deposited with the Fed each day by financial firms via reverse repurchase agreements, as evidence of this excess cash, which the Fed should be able to withdraw without difficulty. Meanwhile, bank reserves stood at $3. trillion, down about $1 trillion from a year ago.

RATE CONTROL REGIME

The level of reserves affects the Fed’s ability to execute monetary policy. When reserves are in short supply, competition for them can cause market-based short-term interest rates to fluctuate wildly and away from the central bank’s target level.

The September reserve shortfall 2019 led the Fed to intervene by borrowing and buying Treasuries to add reserves back into the system to ensure its fed funds rate Targets remained at ideal levels, effectively ending the first effort of quantitative tightening.

The Federal Reserve has expressed confidence that it will be able to withdraw reserves in a way that does not affect its interest rate target. The paper suggests that even in times of ample liquidity, the way banks manage liquidity can challenge this view.

While this article does not address what this means for balance sheet policy, some private sector forecasters are already speculating that the Fed may be forced to slow or halt Bank balance sheets are set to contract this year as reserve levels tighten earlier than expected.

One reason the Fed is expected to more easily manage any type of intermittent reserve shortfall is the existence of its so-called standing repo facility, which allows eligible banks to quickly convert Treasury bills into short-term cash loans . Some want the tool expanded, arguing that it would reduce the likelihood that the Fed would need to intervene in the event of any sort of market turmoil.

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