The US Federal Reserve (Fed) has dropped to its lowest level since 2020, raising concerns about liquidity in the financial system. With pressure from quantitative tightening (QT) policies and interest rate adjustments, does the Fed have enough room to control the situation?
Fed bank reserves fall sharply
The US banking system’s reserves at the Federal Reserve fell to $2.89 trillion, the lowest since October 2020, according to newly released data. This is the largest decline in more than two and a half years, with a $326 billion decline in the first week of January 2024 alone.
The primary cause stems from the balance sheet reduction activities of banks at the end of the year, when they need to ensure compliance with regulatory requirements. This has led to a shift of cash into facilities such as the Fed's overnight reverse repo program (RRP), diminishing liquidity in other items.
Alongside year-end factors, the Fed continues to implement QT policy to withdraw excess cash from the financial system. Additionally, financial institutions are gradually repaying loans from the Bank Term Funding Program (BTFP), adding further pressure on liquidity.
Although policymakers at the Fed have adjusted interest rates for RRP transactions to ease pressure on short-term rates, the "comfortable" reserve level needed by the banking system is estimated to be between $3-3.25 trillion, including a safety buffer. Reserves falling below this threshold raise concerns about the risk of liquidity shortages.
What impact does the debt ceiling have on liquidity?
The question is whether the Fed can continue QT without repeating the turmoil of 2019, when reserves were too low, causing overnight borrowing rates to spike. At that time, the Fed had to intervene to stabilize the market.
Despite lowering the cap on the amount of maturing Treasury securities that are not reinvested last June, the Fed has not announced a specific time to end the QT program. This raises market concerns about the potential for serious liquidity issues if QT continues indefinitely.
The recent reimplementation of the debt ceiling complicates the assessment of the Fed's ideal reserve levels. The Treasury's measures to remain below the debt ceiling often create artificial liquidity in the system, making signals of reserve shortages difficult to identify.
Based on a survey from the New York Open Market Trading Desk, two-thirds of participants predict that the QT program will end in Q1 or Q2 of 2025. However, uncertainty still looms, especially as the Fed faces unpredictable factors from fiscal policy.