The EconomistSeptember 21st 2019 Finance & economics 79T
he federal reservehad plenty to fret
about as it prepared to discuss policy
interest rates on September 17th and 18th.
Trade tensions and wilting global growth
have seen businesses cut back investment
in the second quarter of the year. In manu-
facturing, production and capacity utilisa-
tion have been falling since the end of 2018.
Though the Fed has described jobs growth
as “solid”, some analysts worry that the la-
bour market is wobbling. As expected,
these concerns prompted the central bank
to lower rates for the second time this year,
by 0.25 percentage points, to a target of
1.75-2%. But the meeting was overshad-
owed by turmoil in money markets.
On September 17th, for the first time in a
decade, the Fed injected cash into the
short-term money market. The interven-
tion was needed after the federal funds
rate, at which banks can borrow from each
other, climbed above the Fed’s target. It
rose as the “repo” rate—the price at which
high-quality securities such as American
government bonds can be temporarily
swapped for cash—hit an intra-day peak of
over 10%. On September 17th the Fed of-
fered $75bn-worth of overnight funding, of
which banks took up $53bn. The following
two days it again offered $75bn-worth.
Banks gobbled it up.
That sent shivers down spines. A spik-
ing repo rate was an early warning sign be-
fore the financial crisis. In 2007, as market
participants began to doubt the quality of
collateral backed by mortgage lending,
repo rates jumped as lenders hoarded cash.
The latest jump was unlikely to have
been caused by such doubts. Most collater-
al is now high-quality American Treasury
bonds or bills. Even so, there are reasons to
worry. America’s banks and companies
seem to be short of cash. And during the
turmoil the repo rate stopped tracking the
federal funds rate. This link is the main way
monetary policy influences the economy.
A gap opening between the two deprives
the Fed of its most important policy tool.
Fortunately, the Fed’s interventions
seemed to work. The repo rate returned to
its usual level, close to the federal funds
rate, which in turn is within the range tar-
geted by the Fed. Even so, the turmoil
raised questions about how it plans to han-
dle future cash shortages. The mere pros-
pect of them marks an important shift for
America’s financial system. Before the fi-
nancial crisis the Fed controlled the federal
funds rate using a “corridor”, with a ceiling
and a floor. Banks with too little cash could
borrow at the ceiling rate. But there was no
compensation for extra cash held at the Fed
(the floor interest rate was zero). To keep
interest rates precisely on target the Fed
used “open market operations”, swapping
Treasuries and cash to control liquidity in
the banking system.
Six years of quantitative easing changed
all that. To push down long-term interest
rates, the Fed bought vast quantities of
long-dated Treasury bonds. Its balance-
sheet ballooned to $4.5trn. The holders—
mainly banks—ended up with mountains
of cash. To keep market interest rates at or
above the policy rate, the Fed was autho-
rised by Congress to raise the floor from
zero, compensating banks for their cash
that it held. The ceiling became redundant,
as did open market operations. Only the
floor mattered.
But banks’ cash piles have dwindled of
late. Since late 2017 the Fed has been reduc-
ing its balance-sheet by not reinvesting all
the proceeds when its assets mature. The
balance-sheet shrank from $4.5trn in 2017
to $3.8trn in June this year. Moreover, awider budget deficit means the Treasury
has had to issue more bills and bonds. So
far this year it has issued an average of
$63.9bn-worth per month, net of repay-
ments. During the same period in 2017 the
monthly figure was just $19.6bn. As banks
buy Treasuries, their cash piles fall. The
surplus reserves banks hold in their depos-
it accounts at the Fed fell from $2.2trn in
2017 to $1.4trn now.
No one knows how much surplus cash
banks need to feel comfortable. That de-
pends partly on regulations, which have
increased the amount of cash banks must
hold as a buffer, but also on business senti-
ment. Banks’ near-death experience in
2008-09 has left them with a strong desire
to hold plenty of extra cash. Economists
have attempted to estimate the level at
which banks would start to squirm, most
coming up with estimates of $1.2trn-1.5trn.
Usually banks have at least this much
on hand. But they may not have had on Sep-
tember 16th, for quite benign reasons. That
was the deadline for quarterly corporate-
tax payments, meaning companies asked
banks for more cash than usual. The Trea-
sury had issued $77bn-worth of bills the
previous week. The buyers, mostly banks,
also had to pay on September 16th. The Fed
expected these events, said Jerome Powell,
its chairman, but not such an extreme reac-
tion. As banks’ cash piles shrank, they grew
reluctant to lend to companies and other
counterparties. The repo rate spiked. Some
banks stepped in, lending to companies at
elevated rates. But then those banks tried to
borrow from other banks in the federal
funds market, pushing up the rate. This
prompted the Fed to intervene.
Cash would have become scarce sooner
or later, says Bill English of Yale University.
In a growing economy—especially one
with a rising government deficit—the de-
mand for bank cash increases over time.
The Fed now faces a choice. It could re-
turn to conducting frequent open market
operations to pin down interest rates, as
before the crisis. Or it could keep the cur-
rent system and avert future cash shortages
by expanding its balance-sheet enough to
keep the banking system permanently sat-
urated with liquidity, even as demand for
cash grows. On September 18th Mr Powell
suggested that the Fed would opt for the
latter, saying it wanted reserves to be ample
enough to avoid operations of the sort car-
ried out in recent days. He also announced
technical tweaks that will mean banks are
compensated a little less handsomely for
cash deposited at the Fed, which might en-
courage them to lend a little more in the
repo market instead.
It is unclear how quickly balance-sheet
expansion might be resumed. This week’s
events suggest it may be soon. As Mr Powell
said after the Fed’s meeting, “I think we’ll
learn quite a lot in the next six weeks.” 7NEW YORK AND WASHINGTON, DC
The Fed intervenes in short-term money markets for the first time in a decade
Money markets and the Fed
Hitting the ceiling
Up against itSources:FederalReserveBankofSt.Louis;
FederalReserveBankofNewYork;
Datastream from Refinitiv*Treasuryinflation-
protected securitiesUSovernightreporate,%Primary dealer banks’
net holdings of US
Treasuries and TIPS*, $bnBanks’ excess funds on
deposit at the Federal
Reserve, $trn2015 16 17 18 1905010015020025030000.51.01.52.02.53.030
Aug2 3 4 5 6 9 10 11 12 13 16 17 18
2019 Sep0246810