President Trump spent nearly a year insisting that the Federal Reserve should stop shrinking the massive holdings of government-backed securities on its balance sheet, arguing that the process was reining in the United States economy.
Last week may have vindicated Mr. Trump’s perception that the central bank went too far with the process — often called quantitative tightening, or QT — though for a much more nuanced reason.
The tightening, which took place between late 2017 and last month, did not hit economic growth in a discernible way, as Mr. Trump often suggests. But it did leave an obscure but crucial corner of financial markets vulnerable to short-term disruptions.
To understand what happened, some context is needed. Fed officials decided earlier this year that they wanted to continue setting their main interest rate using an “ample reserves” system — one in which banks have extra cash deposits at the central bank. The approach is attractive partly because it is simple. Instead of intervening in markets to guide rates into place by balancing out supply and demand, as it did before the financial crisis, the Fed announces how much interest it will pay on banks’ currency holdings, and that rate is passed along through the financial system.
To make the procedure work, the Fed holds lots of bonds, which in turn creates excess reserves in the banking sector. But as the central bank pared back its balance sheet, nobody knew for sure just how many reserves needed to stay in the system to make it work.
Last week, markets handed the Fed an answer.
Evidence of trouble first appeared on Sept. 16, when a dollar shortage reared its head in the market for overnight repurchase agreements, or repos — basically short-term loans that hedge funds and banks tap for funds. The cash crunch occurred as corporate taxes came due and government bond issuance sopped up liquid cash.
Usually, banks would have swooped in to supply fresh liquidity before conditions got out of line, attracted by the climbing repo rates. But this time, they hoarded their reserves. The Fed seems to have shrunk its balance sheet to a place where reserves no longer come to the rescue during times of market pressure, rates strategists and economists said.
The central bank had hoped to stop the drawdown before reserves grew so thin that market conditions got messy, based on officials’ public comments over the years and interviews with people familiar with the process. While officials had entertained the possibility that they might need to start occasionally intervening in markets again, doing so regularly was not the plan.
But last week’s shortage forced the Fed to jump into the market to supply cash for the first time since the financial crisis. The New York Fed has announced it will continue to carry out similar operations until Oct. 10.
Last week’s crunch had consequences, albeit short-lived ones. As repo rates jumped, it bled through to the Fed’s main policy tool, pushing the effective fed funds rate too high for a day. That is, in part, why the New York Fed had to jump into the market to smooth things over.
It is clear that the Fed has a problem on its hands. It is not yet clear how it plans to fix it.
Policymakers have three main options for dealing with a reserve shortage. They could resign themselves to regular interventions, like the ones they are performing. They could grow the balance sheet again, adding perhaps a few hundred billion dollars to the portfolio to get back to the comfort zone. Or they could make it easier for banks to swap Treasuries for cash reserves.
The Fed chair, Jerome H. Powell, batted back the first option at his news conference last week.
The current rate-setting approach “is designed specifically so that we do not expect to be conducting frequent open market operations,” Mr. Powell said on Sept. 18.
The Fed will look into when it should resume “organic growth” in the balance sheet, he said. That usually means balance sheet growth that aligns with growth in the amount of cash outstanding and the pace of economic expansion.
If the balance sheet grows just to keep up with the economy, it would not necessarily increase reserves from where they are now, so that alone might not fix the issue.
Asked whether the Fed would consider buying bonds more aggressively to pad reserves, Mr. Powell said “for the foreseeable future, we’re going to be looking at — if needed — doing the sorts of things that we did the last two days.” He added that the Fed was still trying to assess “how much of this really has to do with the level of reserves.”
But Federal Reserve Bank of Boston President Eric Rosengren suggested that reserve scarcity played a key role and that he would favor adding to the Fed’s buffer.
“My own personal preference would be to move toward much more of a buffer than we currently have,” Mr. Rosengren said, speaking Sept. 20. “The reserve scarcity is a solvable problem.”
Last week was not the Fed’s first warning that they might be nearing a point of scarcity.
Rate strategy desks at some primary dealers — the banks who deal directly with the Fed — had warned that the Fed was overestimating how far it could shrink its balance sheet before the crunch arose. Post-crisis regulatory requirements had made banks much less willing to give up their reserves.
In fact, such warnings were fairly consensus. In a survey last November, the median dealer in a New York Fed survey signaled that markets might become strained as reserves dropped to and below $1.5 trillion. Yet the Fed shrunk reserves down to that level, testing its limits.
“They were hearing from everyone in the funding market that things were getting tight,” said Julia Coronado, founder of MacroPolicy Perspectives. “The signs were there.”
Other well-respected experts in money markets believed the central bank had room to go. A presentation by Bank of America’s Terrence Belton at a Columbia University conference last year suggested that the Fed could draw reserves “well below” $1 trillion. A survey of senior financial officers at major banks also suggested a lower level of reserves was sustainable.
But it seems that the market was less flexible. The New York Fed, which has responsibility for market operations and oversees balance sheet stewardship, has suggested that reserves might have been concentrated at a few banks or financial institutions — and were less mobile than they have been in the past.
The Fed will “examine these recent market dynamics and their implications for the liquidity needs in relation to the overall amount of reserves held at the Federal Reserve,” John C. Williams, president of the New York Fed, said Monday.
The clock is ticking to find a solution. The quarter-end on Sept. 30 and the year-end could both see disruptions in the repurchase market. And should the Fed fail to come up with a long-term way to deal with market crunches more smoothly, it could have more serious consequences than a one-day miss on the Fed funds rate.
Repo markets spill into other money market instruments, including the Secured Overnight Financing Rate, a broad measure of how much it costs to borrow cash overnight. That rate is supposed to replace the London Interbank Offer Rate, or Libor, which has been plagued by bank rigging scandals, as a cornerstone for financial market operations.
“You probably don’t want a very volatile overnight rate that’s going to be the replacement benchmark,” said Subadra Rajappa, Societe Generale’s head of United States rates strategy.
Finding a fix will not be painless. It was always the plan to eventually grow the balance sheet again to keep pace with economic growth, but going a step further — growing it to patch up reserves — could confuse onlookers. Some might see the process as a lighter version of the mass bond-buying the Fed carried out during and after the financial crisis to stimulate growth, known as quantitative easing or QE.
That perception would be a mistake, said William C. Dudley, the former head of the Federal Reserve Bank of New York..
“It’s not QE in the sense that you’re not trying to push down long-term interest rates,” he said. “The point is totally different.”
But at a time when the Fed is already under attack from the White House and divided over whether and when to cut interest rates again, it will only make explaining monetary policy more difficult.
“It’s not a problem that they can’t fix — they have the tools, and they’ll use them,” Ms. Coronado said. But “they’re at a point of difficult communication, and at the margin, this doesn’t help.”