The Fed flooded the economy with cash through quantitative easing during the Covid-19 pandemic. Some investors believe that drove up the value of risky assets, although the relationship is far from exact. The Fed created trillions of dollars of central bank reserves, which it used to buy bonds via banks, creating trillions in deposits. Total US bank deposits grew by $5 trillion between the end of 2019 and the April 2022 peak. Keith Horowitz, banking analyst at Citigroup Inc., estimates about $4 trillion of that was created by the Fed’s policies.
Now, QE is going into reverse – becoming quantitative tightening – and banks are worried their deposit base will shrink. As the Fed lets its bond holdings run down – currently to the tune of $95 billion per month – central bank reserves will be pulled from the banking system and to some degree deposits will disappear.
And for investors who think the growth in reserves drove stock markets higher, the promise of shrinking reserves is giving them the jitters. The Fed has already shrunk its balance sheet by $480 billion in the past eight months, coinciding with a rough ride for financial assets of all kinds. Total bank deposits have shrunk by a similar amount, but their holdings of reserves have fallen by even more.
But there’s a very good reason not to get too antsy about all this: The Fed can continue to shrink its balance sheet without slashing reserves. In fact, it expects this to happen naturally, but it could also act to make it happen if it chooses.
That good reason has to do with the Fed’s Overnight Reverse Repurchase facility – aka the ON RRP. Money-market funds, some broker-dealers and government-sponsored entities can use this facility to lend money to the Fed and take Treasuries as security in return. It has provoked curiosity among analysts and investors since the middle of 2021 because it went from being almost never used to having ever-greater volumes of cash ploughed into it, peaking at more than $2.5 trillion at the end of last year.
This was by design: The Fed expanded the kinds of institutions that could use the ON RRP and increased the amount each user could put there in March 2021, the minutes of its monetary policy meeting show. The aim was to put a floor under very short-term market interest rates, which were being pushed downwards by all the excess money in the system and the lack of other places where funds could safely invest their spare cash.
The ON RRP is a tool made to suck excess reserves out of the banking system. If it hadn’t existed, the yields on very short-term Treasury bills would have been negative, or bank deposits would have been significantly larger – or a bit of both.
Since the Fed started tightening monetary policy in March 2022, it has been expecting use of ON RRP to shrink over the longer term and has said so in every set of minutes since. That hasn’t happened yet, likely because money-market funds prefer to keep their cash in the shortest possible maturity investments while interest rates are expected to keep rising, according to economists at Citigroup.
Also, there aren’t many higher-yielding alternatives: Only late last year did rates start to pick up in repo markets – where money-market funds can lend money to brokers or hedge funds, for example.
There is little evidence yet that banks are raising the rates they pay on deposits or savings accounts to compete with money-market funds for cash, according to Matthew Klein, an independent Fed watcher who writes The Overshoot newsletter.
But this will start to happen more. JPMorgan Chief Executive Officer Jamie Dimon said on this month’s earnings call that the bank was going to have to lift rates on savings accounts. Dimon and other bank executives said that competition for funding would limit their prospects for interest-income growth even as the Fed keeps lifting rates.
How fierce this competition ends up being depends a lot on what happens at the ON RRP: If it remains one of the most attractive places to put short-term money, then banks’ deposit bases will come under more pressure and many will need to pay higher rates to get funding.
Citigroup’s Horowitz thinks concerns are overblown. Once a peak for interest rates is in sight, money-market funds will start investing more money in longer-term assets and the ON RRP will shrink. That will ease the pressure on deposits because it will return reserves to the banking system. Horowitz expects total deposits to even grow slightly over the course of this year as that happens.
This should comfort investors worried about the effects of a shrinking Fed balance sheet on wider markets, too. The ON RRP represents more than $2 trillion of Fed assets and liabilities that can be cut away without central bank reserves being pulled from the system.
The Fed can make this facility less attractive any time it wants, which is also useful for protecting money markets against the kind of malfunction caused by a shortage of reserves in September 2019 when the Fed was last shrinking its balance sheet.
There are many theories and fears about what the reversal of QE will do to banks and financial markets. This somewhat obscure $2 trillion money-market facility in fact provides a massive cushion against all of these. Fed tightening can be smoother than you think.
More From Bloomberg Opinion:
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• Strange Times For JPMorgan, Bank of America and Rivals: Paul J. Davies
• What Could Go Wrong for the Federal Reserve in 2023: Bill Dudley
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Paul J. Davies is a Bloomberg Opinion columnist covering banking and finance. Previously, he was a reporter for the Wall Street Journal and the Financial Times.
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