NY Fed: Bank liquidity may be tighter than thought, with policy implications | Techy Kings

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Nov 18 (Reuters) – The way the banking system manages its cash shows the financial system may not be as smooth as many now understand, and that could have implications for how the Federal Reserve manages the size of its balance sheet, a paper from the Federal Reserve Bank of New York said on Thursday. Friday.

That’s because even as institutions like the Fed have flooded the banking system with reserves, many banks continue to manage fast-moving cash inflows and outflows as they always have, and that’s tight, the newspaper said. The authors argue that how to manage this cash position could be an issue for the Fed as it seeks to reduce the size of its bond holdings, which reduces the level of bank reserves in the system.

Banks see the level of their daily reserve balances as a “limited resource,” the paper’s authors said, adding that “even in an era of large central bank balance sheets, rather than financing payments with large reserve balances, we show that outflows remain very sensitive to entry. fees.”

“There is still potential for strategic cash hoarding when reserve balances become low enough,” the researchers wrote.

“As central banks around the world respond to inflation by tightening their monetary stance and shrinking their balance sheets, the potential consequences for the wholesale payments system of the continued drain on central bank reserves will likely be an important input into policymaking,” the paper said.

The paper, by economists at the New York Fed, the Bank for International Settlements and Stanford University, comes as the Fed has been reducing the size of its massive balance sheet as part of a broader effort to tighten monetary policy to lower the peak levels of inflation seen in period of 40 years.

A major part of that effort hinges on rate hikes. But the contraction of its balance sheet, which peaked at $9 trillion compared to $4.2 trillion in March 2020 when the coronavirus pandemic hit, was also key to the campaign. The Fed’s holdings now total $8.6 trillion.

Fed officials are confident that the effort to issue $95 billion a month in Treasuries and mortgage bonds, known as quantitative tightening, should go smoothly largely because banks still have far more cash than they need.

Some point to the more than $2 trillion a day financial firms park at the Fed through repurchase agreements as evidence of this excess cash, which the Fed should be able to pull out painlessly. Meanwhile, bank reserves stood at $3.18 trillion, down about $1 trillion from a year ago.

RATE CONTROL REGIME

Reserve levels affect the Fed’s ability to conduct monetary policy. When reserves are in short supply the competition for them can introduce high levels of volatility in market-based short-term rates, and push them away from the level targeted by the central bank.

A shortage of reserves in September 2019 led the Fed to intervene by borrowing and buying Treasury securities to add reserves back into the system to keep its target federal funds rate at desired levels, effectively ending its first efforts at quantitative tightening.

The Fed has expressed confidence it can draw down reserves in a way that won’t affect its interest rate target. The paper suggests the way banks manage liquidity, even in times of sufficient liquidity, could challenge that view.

And while the paper did not say what that meant for balance sheet policy, some private sector forecasters speculated that the Fed may be forced to slow or stop its balance sheet contraction next year on tight bank reserve levels earlier than expected. .

One reason to expect the Fed to more easily manage any kind of intermittent reserve shortfall is the existence of the so-called Standing Repo Facility, which allows eligible banks to quickly convert Treasuries into short-term cash loans. Some want the tool expanded, arguing it would reduce the chance the Fed would have to intervene in the event of any market turmoil.

Report by Michael S. Derby; Editing by Dan Burns

Our Standards: Thomson Reuters Trust Principles.

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