By Michael S. Derby
NEW YORK (Reuters) – The Federal Reserve appears likely to take a move on Wednesday to take money off its balance sheet, as it enters a more uncertain period in what many see as the final months in its bid to shrink its balance sheet .
Economists broadly expect the Fed to announce that it will cut the interest it pays to money market funds and others to park money in its overnight reverse repo facility (ONRRP) by a larger margin than the expected cut in its policy rate . While the federal funds rate target will be lowered by a quarter of a percentage point to between 4.25% and 4.50%, the reverse repo rate, or RRP, will drop to 4.25% from the current setting of 4.55% .
The Fed has previously adjusted the rate spread between Fed Funds and ONRRP, but those changes were intended to keep the Funds rate within the desired range or to navigate periods of near-zero interest rates. Harmonizing the spread now, Fed watchers think, could give the central bank some flexibility as it unwinds its bond holdings, known as quantitative tightening, or QT.
“It seems logical to me that at some point the [Federal Open Market] The Committee would like to return the overnight RRP offer rate to the lower end of the target range,” said Patricia Zobel, former manager of the New York Fed’s monetary policy implementation team and now head of macroeconomic research and market strategy at Guggenheim Investments.
Changing the interest rate “will be effective in encouraging people to find alternatives” to parking money at the Fed and will also likely lower money market rates, she said.
The Fed’s inverse repo rate is intended to provide a soft floor for short-term interest rates. Together with the interest paid to depository banks for reserves, this helps keep the Fed’s policy rate within its target range.
From near zero usage in the spring of 2021 to a peak of $2.6 trillion at the end of 2022, the reverse repo facility, which primarily takes cash from money market funds, has shrunk as the Fed has shrunk its balance sheet from a record $9 trillion . to $7 trillion by the summer of 2022 by allowing some of its holdings of government bonds and mortgage-backed securities to mature and not be replaced. However, for months, ONRRP totals have remained within a range and have yet to fall below $100 billion.
Fed officials who have weighed in on the issue have indicated that they would like to see ONRRP return to negligible levels, and that this is important for QT. Draining the Fed facility will mean that much of the excess liquidity has been removed and bank reserves can finally begin to decline, allowing QT to eventually come to an end.
Active use of the ONRRP facility “was always something that was intended to be temporary,” said Derek Tang, an analyst at LH Meyer. But “temporary took a long time.”
The facility has made the Fed “a provider of safe assets to the money fund industry,” he said, but that was never the Fed’s intention, and it appears the central bank wants to close that chapter.
STICKY MONEY
Still, observers note that making it less attractive to park cash at the Fed may not be enough: Some money funds are large enough to have trouble putting cash elsewhere.
“Part of the reason the RRP facility is so sticky is that some money funds use RRP as a source of liquidity due to the ease of scaling in and out of the facility on a daily basis – especially late in the day if they are late . -day inflows,” said Gennadiy Goldberg, head of US rates strategy at TD Securities. “I believe that lowering the RRP rate will increase the opportunity cost of holding cash in the RRP facility, but will only marginally reduce the remaining cash in the facility.”
The Fed itself also sees potential challenges in getting money from ONRRRP and QT’s end, given the potential for a reintroduction of the national debt ceiling next year. Possible “substantial shifts” in government treasury management “could mask the effects of ongoing balance sheet reductions on money market conditions and pose difficulties in assessing reserve conditions,” according to the minutes of the Fed’s November meeting.
Banks surveyed by the New York Fed ahead of the Fed’s November policy meeting expected the QT to end in May and the Fed to then keep its balance sheet stable at about $6.4 trillion.
While the minutes of the November meeting suggest to many a high probability of an ONRRRP rate adjustment on Wednesday, analysts at Wrightson ICAP think the Fed will wait until January and cut rates at a meeting when the Fed Funds rate remains unchanged . futures markets currently expect.
Whatever happens on Wednesday, the coming weeks will be turbulent for money markets, adding to the difficulty in predicting an end to QT. Quarter-end volatility has risen with broad expectations that ONRRP will see a spike at year-end, while cash is also expected to flow into the Fed’s standing repo facility, or SRF. But even that is expected to be just a bump in the road, with no greater impact on the QT endgame.
(Reporting by Michael S. Derby; Editing by Dan Burns and Andrea Ricci)
