Fed Looked to Advance Discussion of Reserves Amid Repo Turmoil

(Bloomberg) -- Federal Reserve policy makers, jolted by last month’s disturbances in short-term funding markets, talked at their most recent meeting about the appropriate level of bank reserves the system needs, paving the way for the likely balance-sheet expansion that Chairman Jerome Powell flagged on Tuesday.

The minutes from the Federal Open Market Committee’s Sept. 17-18 gathering showed that participants noted the possibility of resuming trend growth of the balance sheet to help stabilize reserves. Policy makers also suggested that the committee should consider the merits of introducing a standing repurchase agreement facility -- a new tool to control short-term rates.

These discussions came at a time when a spike in overnight funding costs had prompted the New York Fed to step in with a series of temporary operations that is still taking place.

Chairman Powell appears to have already advanced the discussion Tuesday when he said the central bank will buy Treasuries to increase reserves, with the aim of avoiding a repeat of last month’s turmoil in the market for repurchase agreements. The FOMC’s next meeting takes place Oct. 29-30.

Key Insights

• While the spike in the rates in the week of Sept. 16 was a shock to the market, what was more alarming for the Fed was the way the volatility in the repo market pushed the fed funds rate outside of its target band.
  • The effective rate rose to 2.30%, which was outside the Fed’s target band at the time.
• Powell on Tuesday suggested purchases would be made up of Treasury bills and stressed the buying should not be seen as a return to crisis-era quantitative easing programs.
• Regarding the turmoil, Fed staff said money markets became “highly volatile, apparently spurred” partly by large corporate tax payments and Treasury settlements, according to the minutes. They also said that in an environment of greater perceived uncertainty about potential outflows related to corporate tax payments, typical lenders were less willing to accommodate increased demand for dollar funding.
  • Some banks maintained reserve levels significantly above those reported in the Senior Financial Officer Survey about their lowest comfortable level of reserves rather than lend in repo markets, according to the staff. Money market mutual funds also held back some liquidity in order to cushion against potential outflows.
• Some market participants and policy makers, such as New York Fed President John Williams, attributed the tumult to the decline of reserves in the banking system.
• Some observers doubt that the Fed’s plan to add reserves to the system will be enough to shore up funding markets, adding that there’s still a chance of spikes in the repo market at the end of the year.
• There is also a chance the Fed eventually creates a standing repo facility, which would be a tool that would allow eligible banks to convert Treasuries into reserves on demand at an administered rate.
• However, analysts believe any facility won’t be likely until 2020 as there are many lingering issues regarding a potential tool. Bank of America strategists said the Fed should hasten work on such a tool as an “an ‘automatic stabilizer’ to add reserves into the banking system”
• The Fed had been discussing the prospects of a repo facility on and off for months since the beginning of the year. The New York Fed also asked primary dealers earlier this year whether it should consider a new tool to keep money-market rates more under control, according to people familiar with the discussions.
  • St. Louis Fed has published blog posts outlining how such a facility could enable the central bank to implement monetary policy with “minimally ample reserves”

Market Action

• Following the release of the minutes, traders of fed funds futures broadly maintained the amount of easing they expect from the U.S. central bank this year
• The New York Fed’s repo operations are scheduled to continue through October, with both term and overnight operations taking place Thursday

Get More

• A QuickTake about why the Fed is injecting liquidity into the funding markets
• Powell’s Repo Remedy Leaves Money Markets Clamoring for Details
• Repo Rout Didn’t Have to Happen. Powell Is Trying to Avoid Rerun

To contact the reporter on this story: Alexandra Harris in New York at aharris48@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Debarati Roy

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