Bloomberg News
WASHINGTON — With a tentative deal in place to raise the cap on U.S. government borrowing, changes are coming to the Federal Reserve’s balance sheet.
For the Treasury Department to replenish its depleted operating account at the central bank, other holdings at the central bank will have to decrease. For the Fed, which wants a smaller balance sheet, such a rebalancing could be a net positive — but only if it doesn’t disrupt financial stability along the way.
“The fear is that it’s mostly going to come out of reserve balances, meaning it’s coming out of the banking system. If there’s already reserve scarcity — not in the aggregate, but at individual banks — then taking out more reserves is going to stress the system even further,” said Derek Tang, founder of the Washington-based research firm Monetary Policy Analytics. “But that’s not necessarily how it’s going to pan out.”
The Fed’s balance sheet totals $8.4 trillion. Its assets include securities and lending facilities. Its liabilities include currency, commercial bank cash — known as reserves — obligations for reverse repurchase agreements — or repos — and the Treasury General Account.
Since the U.S. hit the debt ceiling in January, the Treasury has drawn down its general account from more than $570 billion to less than $50 billion, paying out liabilities faster than it can generate revenue. Once the agency is free to issue debt again, rebuilding its pool of operating capital is expected to be a top priority.
“The Treasury likes to hold enough cash to pay a week’s worth of bills. That has typically translated to a cash balance of around $600 to $700 billion. As of Thursday, the cash balance was $39 billion,” said Stephen Stanley, chief U.S. economist at Santander US Capital Markets. “So the Treasury is going to want to ramp up borrowing quickly to get the cash balance back to normal.”
The Treasury is expected to rebuild its account by issuing short-term securities known as Treasury bills, or T-bills, which mature after one year or less. The question is whether this debt will be purchased by bank depositors, leading to an outflow of reserves, or by money market funds, leading to a reduction in the Fed’s overnight reverse repurchase program, or ON RRP.
Steven Zeng, rates strategist at Deutsche Bank, said this could have implications both on banks’ cost of funding and the Fed’s future actions on shrinking its balance sheet.
“If reserves drain too quickly, then it could potentially disrupt or derail the Fed’s plans for [quantitative tightening],” Zeng said. “But, if reserves drain at a slower pace than ON RRP balances, then the Fed should be able to continue running QT in the background uninterrupted.”
Bank of America Securities analyst Mark Cabana said in a note issued last week that money market funds are likely to account for a majority of the uptake, noting that they are more sensitive to the relative decline in the cost of T-bills that will come with a surge in issuance. If this happens, the impact on bank deposits will likely be minimal.
But Cabana noted that dynamic is not guaranteed and if retail buyers account for a bulk of the asset purchases, it could impact banks’ cost of funding.
“We are confident in our view but recognize we could be wrong,” he wrote. “If we are wrong and more cash comes out of reserves this would place additional strain on the banking system and it may drive reserve/liquidity scarcity at mid- to large-sized banks.”
For banks, the supply of reserves is the most critical element of the balance sheet. Because of this, the Fed targets an “ample reserve” regime, one in which there is more than enough liquidity for banks to settle payments and offset potential losses.
When reserves become scarce, banks can end up bidding up funding costs above the Fed’s target range. This happened in September 2019, when a significant issuance of Treasury debt coincided with a corporate tax deadline. Bank deposits flowed into the Treasury General Account and reserves became scarce. The ensuing volatility caused the Fed to end its two-year-old balance sheet reduction effort and begin buying securities again.
The Fed is already in the process of reducing the potential supply of reserves in the system by allowing $95 billion of securities to roll off its balance sheet monthly. The Treasury’s draw down of its general account has muted the impact of this reduction, by allowing more reserves to take up a bigger portion of the balance sheet than they otherwise would.
The combination of fewer potential reserves and more nonreserve liabilities is a “double whammy” for banks, Tang said — but unlike the 2019 episode, it is not an unexpected one.
“It’s part and parcel of a tightening campaign. It’s what the Fed wants in a way,” he said. “Whether it unfolds in exactly the way they planned remains to be seen, but it isn’t necessarily unwelcome. They just need to watch the market closely so that they can intervene if they need to.”
Some analysts are confident the replenishment of the Treasury General Account can be orchestrated without government intervention. They point to the 2021 introduction of the standing repo facility, an emergency liquidity program designed to provide funding when reserves are in short supply, as a key addition to the Fed’s stability toolkit. The Fed created the facility in response to the 2019 flareup and the Treasury securities market disruption that took place at the onset of the COVID-19 pandemic.
Others say the elevated use of the ON RRP, which has remained above $2 trillion daily since last spring, indicates that the reserves are ample.
Fed Gov. Christopher Waller has often pointed to the $2 trillion figure as a buffer for the reserve supply. If banks were truly in need of funding, he has said, they would increase the rate of interest they pay on deposits to draw customers away from money market funds.
But the supply of reserves is not distributed evenly throughout the banking system. Tang noted that a small amount of fed funds rate trading is already happening well above the Fed’s target range, indicating that some banks feel the need to pay up for funding.
Michael Redmond, an economist with Medley Advisors who previously worked at Federal Reserve Bank of Kansas City and the Treasury, said he anticipates the resurgence of the Treasury General Account to exacerbating problems for banks that are already feeling the stress of having to pay out higher interest rates, but he does not expect it to be broadly destabilizing.
“There’s definitely a profitability challenge,” Redmond said. “But there’s not really a quantity challenge in terms of the reserves that are out there in the system.”
