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After curbing year-end volatility, Fed weighs future of repo operations

After warding off substantial volatility in overnight lending rates at the close of 2019, the Federal Reserve is eyeing next steps and evaluating when it may begin dialing back its temporary liquidity injections.

The Fed has been pumping billions of dollars of liquidity into the financial system since mid-September, when a liquidity crunch hit markets and caused the Fed's benchmark interest rate to breach its 25-point target range.

The central bank avoided a potential replay of that episode at the close of 2019, in large part because of those liquidity injections that have caused its balance sheet to grow to about $4.17 trillion, up from approximately $3.8 trillion in September.

The Fed's "pre-emptive measures seem to have worked," having kept short-term borrowing rates in check through the end of the year, a period that often sees volatility in short-term rates, according to Sean Darby, global equity strategist at Jefferies. The Fed's benchmark federal funds rate stayed unchanged at 1.55% through year-end, and the secured overnight financing rate rose only 1 basis point to 1.55% on Dec. 31.

With the end of 2019 in the rearview mirror, Fed officials are now turning their focus to when they may begin easing up on their temporary liquidity injections. They are also addressing other longer-term questions that they had set aside until the start of the new year.

Minutes of the Federal Open Market Committee's December 2019 meeting, released Jan. 3, detailed some of those discussions.

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'Gradual reduction' in repo operations expected

One major issue the Fed is considering is when it will begin reducing its repurchase agreements. Under those repo operations, the Fed buys Treasurys and other securities from primary dealers in the private sector and agrees to sell them back at a later date.

That approach temporarily increases the amount of reserves available in the banking system, ensuring sufficient liquidity during periods of heightened demand for cash.

The Fed's temporary repo purchases have amounted to more than $200 billion a day, but the central bank has also been buying $60 billion a month in Treasury bills so it can permanently boost bank reserves going forward.

The plan is for those latter purchases to gradually bring banks' reserves back to or above the levels they were at immediately preceding the bout of money market volatility that occurred in mid-September.

Lorie Logan, a top New York Fed official who manages the central bank's portfolio, briefed Fed officials in December of "expectations to gradually transition away from active repo operations" in 2020 as the monthly T-bill purchases "supply a larger base of reserves," according to minutes of the December FOMC meeting.

The Fed's planned repo operations could begin seeing a "gradual reduction" starting in mid-January, though "some repos might be needed at least through April," when tax payments to the U.S. Treasury will sharply reduce reserves at banks, the minutes showed.

The central bank will likely "err on the side of caution" in determining when to ease off its repo purchases, BCA Research U.S. bond strategist Ryan Swift wrote in a note to clients.

"That is, the Fed will not completely unwind its repo operations until it is confident that reserve supply is comfortably above demand," Swift added.

Standing repo facility

Fed officials have also considered whether they should launch a standing repo facility, which would give firms a permanent way to easily trade their stock of Treasury securities for reserves at the Fed.

Having a facility in place may help at times of unusually high demand for cash that lead to declines in bank reserves, Chicago Fed President Charles Evans told CNBC in an interview. But another option, Evans added, is for the Fed to keep growing its balance sheet to a level where bank reserves are ample enough to deal with those periods of higher cash demand.

After months of discussions, Fed officials do not appear to be much closer to deciding on whether they should launch a standing repo facility — in addition to several key details governing what that facility might look like and who could use it. The FOMC minutes indicated Fed officials will discuss that topic at future meetings.

Fed officials "need to debate" the merits of a standing repo facility, including whether it would help ensure the Fed balance sheet still provides a sufficient amount of reserves while not growing excessively large, Dallas Fed President Robert Kaplan said in a separate CNBC interview.

"Now that we've gotten past year-end, I want to find ways to grow the balance sheet more slowly," said Kaplan, adding that he has not come to a conclusion on what the best approach would be.