Federal Reserve to resume Treasury purchases to prevent a cash crunch
The Federal Reserve will soon resume purchases of short-term US Treasury bonds to expand its balance sheet in hopes of preventing a repeat of the recent disruption in overnight “repo” markets, chairman Jay Powell said on Tuesday.
Speaking in Denver, Mr Powell said the action differed from the crisis-era programme known as quantitative easing, or QE, because it was intended to facilitate short-term lending rather than to stimulate the US economy.
“I want to emphasise that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programmes that we deployed after the financial crisis,” he told the National Association of Business Economists.
Mr Powell also appeared to confirm market expectations of a 25 basis-point cut in US interest rates at the Federal Open Market Committee’s October 29-30 meeting to add further insurance against uncertainty over “trade, Brexit and other issues”.
“We will act as appropriate to support continued growth, a strong job market and inflation moving back to our symmetric 2 per cent objective,” he said.
The Fed’s preferred inflation measure currently sits at 1.8 per cent, and has been at or below the US central bank’s target for most of the recovery. With the word “symmetric”, Mr Powell downplayed the risk of overshooting the Fed’s target.
In recent weeks, the Federal Reserve Bank of New York has injected billions of cash reserves into short-term lending markets to ease the pressures that bubbled up in September and sent the cost of borrowing cash overnight via repurchase, or repo, agreements as high as 10 per cent.
Those measures have brought the so-called repo rate back within a normal range — about 1.8 per cent — but strategists say such pressures could crop up again without a more permanent fix.
“This was the only sustainable and permanent solution,” said Priya Misra, head of global rates strategy at TD Securities. “The risk is that this gets miscommunicated as QE. Operationally it will look a lot like QE, but it is not.”
Mr Powell reflected such concerns when he took questions after his speech. “Not QE,” he said. “Did I mention that?”
When the Fed buys Treasuries to expand its balance sheet, it credits banks with an equal amount of reserves. For banks those reserves are the most liquid and reliable kind of dollar-denominated assets — like deposits in a cheque account.
After the Fed began shrinking its balance sheet in 2018, reserves dropped, too. Policymakers had expected that banks still holding large amounts of reserves would lend them overnight into repo markets, keeping short-term interest rates low. But that did not happen when the repo rate rose in September.
“It can be that reserves are just kind of less . . . flexible in the markets than we had anticipated,” Mr Powell said.
Without enough reserves in the banking system, even normal, predictable demand for reserves, such as when corporations need cash to pay taxes, can “lead to outsized movements in money market interest rates”, Mr Powell said.
“This volatility can impede the effective implementation of monetary policy, and we are addressing it,” he added. “Indeed, my colleagues and I will soon announce measures to add to the supply of reserves over time.”
Mr Powell did not offer details on the level of reserves the Fed would add to avoid market disruptions. “We think that level [of reserves] might be at or maybe a bit above where we were in early September,” he said. “We think that all of this is still uncertain. We’re still learning.”
In the first week of September, banks held $1.34tn in reserves at the Fed. That level has since dropped to $1.26tn.
“What we don’t have here is the exact size [of the asset purchases], and that is what I’m concerned about going into the FOMC meeting,” said Subadra Rajappa, head of US rate strategy at Société Générale. “The concern here is that when the dust settles people may start to ever so slightly price this in as more accommodative monetary policy.”
Ms Rajappa said the bond market “took chair Powell’s comments at face value”. Yields on two-year Treasury bills fell 4bp to 1.42 per cent, indicating a rise in price. Meanwhile, the 10-year Treasury yield climbed 3bp to 1.52 per cent.
Mr Powell has said the Fed would consider resuming “organic” expansion of its balance sheet — meaning buying enough assets to maintain the level of reserves as other liabilities on its balance sheet, such as physical currency or deposits from the Treasury, grow. Physical currency grows at about $50bn every six months. Deposits from the Treasury expand irregularly. In the first half of 2018, they grew by $140bn. In the first half of 2019, they shrank by $30bn.
“As we indicated in our March statement on balance sheet normalisation, at some point we will begin increasing our securities holdings to maintain an appropriate level of reserves,” Mr Powell said. “That time is now upon us.”
Strategists have warned that “organic” expansion of the balance sheet may not add reserves fast enough to return short-term funding markets to their normal functioning, making the case instead for the Fed to buy anywhere from $200bn to more than $300bn of shorter-dated Treasury bills over the next six months.
Brendan Greeley and Colby Smith