Recent spikes in short-term borrowing rates reflect looming liquidity shortages that the Federal Reserve may soon have to address, even if a long-term solution may not be needed right away.
Jumps in overnight borrowing rates prompted a response from the New York Fed, whose trading desk temporarily injected liquidity into the banking system on Sept. 17 and did so again on Sept. 18.
The move in overnight rates was likely due to a confluence of factors that required banks to pull reserves out of the system so they could meet customers' demands, analysts say. For example, a Sept. 15 deadline for corporate tax payments required companies to use their bank deposits to pay their tax bills, draining banks' reserves as institutions transferred corporate customers' money to the Treasury Department. Separately, a higher-than-usual settlement of U.S. Treasury securities required investors to take out cash and absorb some $54 billion in newly issued Treasurys.
Those factors resulted in shortages of cash across the financial system, prompting a jump in demand in overnight borrowing markets and a bounce in the interest rates that companies pay to borrow money for short periods.
Analysts say the New York Fed may have to make more repo purchases in the coming days to help alleviate liquidity pressures, as the purchases temporarily add bank reserves and ensure more cash is sloshing around in the system during the day.
But those purchases are only short-term fixes, analysts say. A longer-term solution revolves around the future of the Fed's $3.8 trillion balance sheet, and the liquidity crunch accelerates the timeline for the Fed to act. Those actions may include expanding its assets again by buying Treasurys and launching a so-called standing repo facility to help boost liquidity.
The Fed's repo purchases should not "be seen as an admission of reserve scarcity" in the banking system, and the standing repo facility discussions are still in early stages, J.P. Morgan analysts wrote in a research note.
But Fed officials are facing "a trade-off between waiting too long and having some problems in the near term, versus waiting a little longer" to ensure they get the launch of a standing repo facility correct, said Michael Pugliese, an economist at Wells Fargo Securities.
"No one really knows exactly when it's all going to be resolved, but I think today makes it more likely than not that it's coming sooner rather than later," Pugliese said in a Sept. 17 interview.

Technical tweak possible at FOMC meeting
The volatility in money markets came as Fed officials were gathering for the Sept. 17-18 meeting of the Federal Open Market Committee. The FOMC is expected to cut interest rates at the meeting, as officials' worries about the U.S. economic outlook and below-target inflation persist.
Now, the Fed may also have to announce a technical tweak to ensure its benchmark federal funds rate goes back to trading within the 25-basis-point range the Fed targets. The spike in overnight rates spilled over into the federal funds rate, which jumped from 2.14% to 2.25% on Sept. 16. That put it just within the Fed's current 25-basis-point target range of 2% to 2.25%.
On Sept. 17, liquidity pressures continued, and the federal funds rate breached the top of the range, settling at 2.30%.
Unexpected spikes in the fed funds rate have occurred in the past but had previously been kept within the target range. The past jumps in the fed funds rate had prompted the Fed to make technical tweaks to the interest rate it pays banks for the excess reserves they hold at the Fed, known as IOER.
Cutting the IOER rate by more than the fed funds rate could help bring the latter down, but it "fails to solve the underlying problem of reserve scarcity," Priya Misra, TD Securities' global head of rates strategy, wrote in a research note.

Bank reserves will keep declining
Scarcity in bank reserves would pose a problem for the Fed, which announced in January that it would stick with its postcrisis framework of operating monetary policy with ample reserves in the banking system.
Before the financial crisis, the Fed kept bank reserves to a minimum. The New York Fed's trading desk — through purchases like the ones it conducted this week — added or removed reserves from the system depending on whether the Fed wanted to loosen or tighten monetary policy.
But the Fed massively expanded its balance sheet to help the economy recover from the crisis, purchasing Treasurys and mortgage-backed securities, which resulted in a peak in assets of $4.5 trillion. The Fed paid for its "quantitative easing" purchases by essentially expanding banks' reserves.
The reversal of that process, known as quantitative tightening, began in 2017 and led to a decline in bank reserves. The Fed wrapped up its gradual balance sheet cuts in August, and its assets have remained at roughly $3.8 trillion since.
Bank reserves, though, are expected to keep declining in the coming months even though the Fed is holding its balance sheet steady.
That is because the Fed's other main liabilities — currency; a deposit account that the Treasury Department keeps at the Fed; and a foreign repo pool that foreign central banks and other international official bodies use to keep dollar buffers at the Fed — have picked up recently or are expected to keep gradually rising. Growth in those liabilities eat into bank reserves.
"What'll happen is, organically, very gradually, currency and other non-reserve liabilities will grow, and reserves will shrink," Fed Chairman Jerome Powell told reporters in March.

Fed may start growing its balance sheet again this year
At some point, Powell said, bank reserves will decline to a level that will require the Fed to expand its balance sheet again to avoid reserve shortages.
Fed officials and market analysts are unsure when exactly reserve shortages may begin popping up — or if they already have. But the jump in overnight rates at least suggests the Fed is nearing that mark, analysts say.
"The fact that you see money market rates becoming more volatile ... strengthens the argument for an earlier start to that balance sheet expansion," said Steven Zeng, U.S. rates strategist at Deutsche Bank.
A recent report from the New York Fed suggested the balance sheet may begin growing again "as soon as late 2019 or as late as 2025," underlining the substantial uncertainty in any assumptions surrounding the Fed's balance sheet.
The report outlined some possibilities for the Fed's balance sheet, drawn from June 2019 surveys it conducted with primary dealers and market participants. The survey asked respondents for their expectations of what the Fed's balance sheet will look like in 2025, assuming the Fed does not have to cut rates to near-zero levels again during that time.
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Under a scenario of smaller liabilities, the Fed's balance sheet would have about $3.8 trillion in assets in 2025, roughly unchanged from current levels and implying plenty of room for reserves to keep declining.
Under a scenario envisioning larger liabilities at the Fed, the central bank's balance sheet would have to expand to about $4.7 trillion in 2025. A median-liabilities scenario would put the Fed balance sheet at about $4.3 trillion in 2025. Both of those imply the Fed would hit reserve shortages sooner.
Mark Cabana, a Bank of America Merrill Lynch rates strategist, said the Fed could potentially announce the beginning of those purchases in its Sept. 18 decision.
"This is not our base case for now, but we see substantial risks of such an action. Such a statement would imply that permanent balance sheet growth and outright purchases are necessary," Cabana wrote in a note to clients.
The need for the Fed to start buying Treasurys again may bring back memories of the Fed's postcrisis quantitative easing purchases. But the new Treasury purchases would be focused on ensuring that the Fed's balance sheet keeps up with growth in liabilities — not on easing credit conditions by aiming to lower long-term interest rates.
The New York Fed report described those eventual purchases as "reserve management purchases." When the time comes, the Fed will have to make that message clear to ensure markets "don't confuse it with asset purchases actively targeting lower yields," Deutsche Bank's Zeng said.
"The Fed absolutely has to emphasize that this is natural balance sheet growth, and it's not QE," Zeng said.

