A key line item on the Federal Reserve's balance sheet has fallen to its lowest level in nearly four years, raising questions about the central bank's runoff plans going forward.
The Fed's overnight reverse repurchase agreement program, or ON RRP, fell to $85 billion this week. This is the first time use of the facility has been below $90 billion since April 2021, according to data tracked by the Federal Reserve Bank of St. Louis.
The Fed uses the ON RRP to borrow assets from money market funds and other financial institutions overnight, then repay them the following day with a modest amount of interest. Officials have long said the facility's usage represents
Officials have also noted that high nightly balances in the facility — in excess of $2 trillion for much of 2022 and 2023 — served as a buffer for the banking industry as the Fed sought to
This runoff process — known as quantitative tightening, or QT — is part of the Federal Open Market Committee's effort to tighten monetary policy in response to elevated inflation. Whereas the Fed's policy rate impacts short-term interest rates, balance sheet adjustments are intended to affect longer-term rates by signaling, in this instance, a less accommodative policy stance.
As the Fed sheds assets — namely Treasuries and mortgage-backed securities — it mechanically shrinks its liabilities, too. Thus far, the $2 trillion of asset reduction has been almost entirely offset by falling ON RRP use. The question Fed policymakers have been asking is at what point the wind-down starts to impact another key liability at the central bank: reserves.
Reserves are funds held by commercial banks at the Fed. They are used as a source of liquidity and to settle interbank transactions. When demand for reserves exceeds supply, banks tend to charge each other more to trade them, a process that drives up the Fed's benchmark interest rate, the federal funds rate.
The Federal Reserve Bank of New York's Reserve Demand Elasticity database, which tracks how responsive the cost of reserves is to changes in demand, indicates that reserves are "abundant" or well in excess of what banks need. The Fed is aiming to reduce the supply of reserves to "ample," or only slightly more than what banks need.
The Fed
During his most recent post-FOMC meeting press conference at the end of January, Fed Chair Jerome Powell said the central bank intends to taper the runoff rate further as reserves become less abundant, but noted there was no set timeline for such a change.
"We're closely monitoring a range of indicators to assess conditions and that should provide signals when reserves are approaching a level that could be judged as 'somewhat above ample,'" Powell said. "We stand ready to take appropriate action to support the smooth transmission of monetary policy, including to adjust the details of our approach for reducing the size of our balance sheet in light of economic and financial developments."
