Here’s why a liquidity flood could create a conundrum for the Fed
While bond traders worry about another potential sale of long-term US Treasuries, those who rely on shorter maturities face the opposite problem.
A flood of liquidity entering money markets put pressure on overnight interest rates, while increasing the use of an obscure Federal Reserve facility to its highest level since the pandemic triggered a global flight to safety last year. This, in turn, has raised concerns for the US central bank, which may be on the verge of losing control over its benchmark policy rate.
The Fed’s overnight repo facility brought in $ 142.17 billion on Tuesday, the largest such transaction since April 2020.
The facility allows lenders to offer funds to the central bank in exchange for US Treasuries and similar safe-haven assets at negligible interest rates. In doing so, the Fed can limit downward pressure on the Fed’s benchmark interest rate and keep it within its prescribed range.
Part of the reason for the Fed’s increased adoption of this facility, according to John Canavan, analyst at Oxford Economics, is that the influx of liquidity into money market funds needs a place to find housing.
The US Treasury Department accounts held at the Fed are expected to shrink as the Treasury reduces its cash reserve to fund the Biden administration’s fiscal stimulus plans. This increases the reserves of the banks who will look for places to temporarily park the funds, one of the selling points being the Fed’s repo facility.
See: 5 reasons why negative repo rates are different from the latest overnight finance crisis
But its increased use has shed light on a conundrum the central bank has faced in recent months.
Overnight loan rates, whether in the repo market or the treasury bill market, have periodically threatened to fall below zero. The concern is that sliding these short-term borrowing rates could, in turn, push the Fed’s interest rate down closer to the bottom of its 0.25% to 0% range. The Fed’s effective federal funds rate was 0.07% on Tuesday.
This prompted the Fed to change the interest rate paid on excess reserves that banks park at the central bank or the overnight reserve repo facility rate, fixes that could ease the pressure on the markets. monetary.
Still, Amherst Pierpont’s Stephen Stanley argues that as long as the Fed benchmark rate remains in positive territory, the central bank is unlikely to act at Wednesday’s meeting.
