Do we take the FOMC at its word or focus on the Fed’s repo borrowing program?
By Jeff Huther
Quantitative tightening (and other factors) reduced the Fed’s balance sheet by $100 billion a month in the second half of 2023. One consequence of tightening is that usage of the Fed’s repo borrowing program (“ON RRP”) will likely fall to zero by the end of 2024 Q2. ON RRP usage is significant because it has alleviated the need for declines in reserves. The end of ON RRP usage will mark the beginning of a steady decline in reserves.
The FOMC has said that the pace of quantitative tightening will slow before ceasing altogether and the determining factor will be when bank reserves become less “abundant.” In contrast, some market observers have cited the rapid decline in usage of the Fed’s Overnight Reverse facility as an indication that quantitative tightening will slow or stop in 2024.
The Fed has been reducing the size of its balance sheet since mid-2022 by letting the securities it holds roll off when they mature. Going into 2023, there were concerns that quantitative tightening would cause bank reserves (and deposits) to fall while money market mutual funds continued to maintain their share of Fed liabilities in repos that they accumulated in 2021 and 2022. Bank and MMMF activity allayed those concerns last year (see chart).
Despite QT, bank holdings of reserves actually rose in 2023 Q4 while ON RRP usage declined sharply. Precautionary balances of reserves shot up at the time of the Silicon Valley Bank failure and remained high through 2023 Q3 before rising in Q4. In contrast, the decline in ON RRP usage began in 2023 Q2 and remained strong through the rest of the year.
The main lenders to the Fed through the ON RRP facility are money market mutual funds, which have grown rapidly since the SVB failure. The MMMF decline in ON RRP usage has been driven by relatively high rates on, and larger quantities of, Treasury bills and because expectations that the Fed may not be hiking rates again have made long dated Treasury bills more attractive.
Based on declines in the ON RRP in the second half of 2023, usage would drop to zero by the end of 2024 Q1, indicating that bank reserves will start to fall in 2024 Q2. The ON RRP decline likely slows in 2024 because of changes in other items on the Fed’s balance sheet. One other liability in particular, repo transactions with foreign central banks, rose quickly in 2023 and, based on historical patterns, is not likely to grow in 2024. The Bank Term Funding Program, which the Fed has committed to maintain through March 11, will help to keep reserves in the banking system into March 2025 (the terms of the BTFP allow banks to borrow for up to one year) but is unlikely to grow past March 2024.
The FOMC’s stated view of the end of quantitative tightening, based on reserves, and market observers’ view, based on ON RRP, are not easily reconciled. If we take the FOMC at its word, quantitative tightening will not end until sometime after reserves start to decline, possibly well after the declines have begun falling. If we focus on ON RRP, as some market observers have, the end of quantitative tightening may be right around the corner. Bet on the horse of your choice.
Jeff Huther is VP, banking and economic policy research at ABA.
