A key indicator of
The Federal Reserve's overnight reverse repurchase agreement, or
For banks, this was a desired outcome of the Fed's effort to
"What we've seen is the decline in the Fed holding has mostly come through on the liability side in terms of a decline in reverse repos, rather than reserves," Derek Tang, co-founder of Monetary Policy Analytics, said. "This is, of course, welcome news to the Fed, because the Fed wants to make sure that there are enough reserve balances in the banking system to operate smoothly. So that's good news."
Yet, as participation in the ON RRP — through which nonbank financial firms buy assets from the Fed with an agreement to sell them back to the central bank at a higher price the next day — shrinks, some in and around the financial sector worry that funds are being redirected to riskier activities.
Darin Tuttle, a California-based investment manager and former Goldman Sachs analyst, said the decline in ON RRP usage has coincided with an uptick in stock market activity. His concern is that as firms seek higher returns, they are inflating asset prices through leveraged investments.
"I tracked the drawdown of the reverse repo from April when it started until about the beginning of August. The same time that $600 billion was pumped back into the markets is when markets really took off and exploded," Tuttle said. "There's some similarities there in drawing down the reverse repo and liquidity increasing in the markets to take on excessive risk."
The Fed established the ON RRP facility in September 2014 ahead of its push to normalize monetary policy after the financial crisis of 2007 and 2008. The Fed intended the program to be a temporary tool for conveying monetary policy changes to the nonbank sector by allowing approved counterparties to get a return on unused funds by keeping them at the central bank overnight. The facility sets a floor for interest rates, with the rate it pays representing the first part of the Fed's target range for its funds rate, which now sits at 5.25% to 5.5%.
For the first few years of its existence, the facility's use typically ranged from $100 billion to $200 billion on a given night, according to data maintained by the Federal Reserve Bank of New York, which handle's the Fed's open market operations. From 2018 to early 2021, the usage was negligible, often totaling a few billion dollars or less.
In March 2021, ON RRP use began to climb steadily. It eclipsed $2 trillion in June 2022 and remained above that level for the next 12 months. Uptake peaked at $2.55 trillion on December 30 of last year, though that was partially the result of firms seeking to balance their year-end books.
While it is difficult to pinpoint why exactly ON RRP use has skyrocketed, most observers attribute it to a combination of factors arising from the government's response to the COVID-19 pandemic, including the Fed's asset purchases as well as government stimulus, which depleted another liability item on the Fed's balance sheet: the Treasury General Account, or TGA.
Regardless of how it grew so large, few expected the ON RRP to ever reach such heights when it was first rolled out. Michael Redmond, an economist with Medley Advisors who previously worked at Federal Reserve Bank of Kansas City and the Treasury Department, said the situation raises questions about whether the Fed's engagement with the nonbank sector through the facility ultimately does more harm than good.
"The ON RRP, when it was initially envisioned as a facility, was not expected to be this actively used. The Fed definitely has increased its footprint in the financial system, outside of the usual set of counterparties with it," Redmond said. "The debate is whether that increases financial instability, because obviously it is nice to have the stabilizing force of the Fed's balance sheet there, but it also potentially leads to counterproductive pressures on private entities that need to essentially compete with the Fed for reserves."
Fed officials have maintained that the soaring use of the facility should not be a cause for concern. In a June 2021 press conference, as ON RRP borrowing was nearing $1 trillion, Fed Chair Jerome Powell said the facility was "doing what it's supposed to do, which is to provide a floor under money market rates and keep the federal funds rate well within its — well, within its range."
Fed Gov. Christopher Waller, in public remarks, has described the swollen ON RRP as a representation of excess liquidity in the financial system, arguing that counterparties place funds in it because they cannot put them to a higher and better use.
"Everyday firms are handing us over $2 trillion in liquidity they don't need. They give us reserves, we give them securities. They don't need the cash," Waller said during an event hosted by the Council on Foreign Relations in January. "It sounds like you should be able to take $2 trillion out and nobody will miss it, because they're already trying to give it back and get rid of it."
But not all were quite so confident that the ON RRP would absorb the Fed's balance sheet reductions. Tang said there have been concerns about bank reserves becoming scarce ever since the Fed began shrinking its balance sheet last fall, but those fears peaked this past spring, after the debt ceiling was lifted and Treasury was able to replenish its depleted general account.
"If the Treasury is increasing its cash holdings, then other parts of the Fed's balance sheet, other liabilities have to decline and there was a big worry that reserves could start declining very quickly," Tang said. "The Treasury was going from $100 billion to $700 billion, so if that $600 billion came out of reserves, we could have been in trouble."
Instead, the bulk of the liabilities have come out of the ON RRP, a result Tang attributes to money market funds moving their resources away from the facility to instead purchase newly issued Treasury bills.
The question now is whether that trend will continue and for how long. While Fed officials say the ON RRP facility can fall all the way to zero without adverse impacts on the financial sector, it is unclear whether it will actually reach that level without intervention from the Fed, such as a lowering of the program's offering rate or lowering the counterparty cap below $160 billion.
A New York Fed survey of primary dealers in July found that most expected use of the ON RRP to continue falling over the next year. The median estimate was that the facility would close the year at less than $1.6 trillion and continue falling to $1.1 trillion by the end of next year.
Those same respondents also expect reserves to continue dwindling as well, with the median expectation being less than $2.9 trillion by year end and roughly $2.6 trillion by the end of next year. As of Aug. 31, there were just shy of $3.2 trillion reserves at the Fed.
"The Fed's view is that there are two types of entities with reserves, the banks that have more than enough and they don't know what to do with, and the ones that are having some problems and need to pay up to attract deposits, which ultimately are reserves," Redmond said. "When there are fluctuations in reserves, it's hard to tell how much of that is shedding of excess reserves by banks that are flush with them, and how much is a sign that this is going to be a tougher funding environment for banks."
Tuttle said a balance-sheet reduction strategy that relies on a shrinking ON RRP is not inherently risky, but he would like to hear more from the Fed about how it sees this playing out in the months ahead.
"We have gotten zero guidance on the drawdown of reverse repo," he said. "Everything is just happening in the shadows."
