(Bloomberg Opinion) — Investors are worried that a flood of cash could soon disrupt U.S. money markets, as the Treasury rushes to rid itself of money that Congress won’t allow it to keep. It’s a possibility that the Federal Reserve would do well to anticipate.
Two phenomena have converged to create the impending deluge. For one, to ensure the funds needed to deliver trillions of dollars in pandemic relief, the Treasury has built up a huge cash balance at the Fed — currently about $1.6 trillion. Also, back in August 2019, Congress suspended the federal debt ceiling for two years — and has stipulated that when the ceiling comes back into effect on August 1, Treasury should be holding no more than about $120 billion in cash. This constraint was intended to prevent Treasury from preparing for the debt limit by accumulating an extraordinarily large cash balance.
So to meet the Congressional requirement, Treasury will have to draw down its cash balance at the Fed. Combined with the $120 billion a month that the central bank is already spending to buy securities and keep long-term interest rates low, this will cause cash reserves that banks hold at the Fed to soar — likely topping $5 trillion this summer, up from about $3.4 trillion now.
Market observers worry that this wall of liquidity could push short-term interest rates into negative territory. Although no one can be sure of the ramifications, this could prove disruptive to money-market mutual funds and to the functioning of short-term lending markets more generally. The surge in reserves will also add to banks’ assets, potentially causing them to bump up against regulatory leverage requirements, which limit the ratio of their total assets to equity capital. This, in turn, could cause some banks to pull back from lending against securities, potentially triggering yet another disruption in the “repo” market, a crucial source of financing for hedge funds, investment banks and many other institutions. Banks also might take steps to encourage households and businesses to take their deposits elsewhere.
What can the Fed do? For one, at their next policy-making meeting in mid-March, officials could slightly bump up the interest rates the central bank pays on bank reserves (currently 0.10%) and on its borrowings in the repo market (currently zero). A slightly higher floor on such rates might help prevent other short-term rates, such as yields on Treasury bills, from going negative. There’s precedent for such a move: The Fed has made technical adjustments to these rates before in order to ensure that the federal funds rate stays within the Fed’s target range.
Beyond that, the Fed should extend its temporary exemption of bank reserves and Treasury securities from leverage-ratio calculations (the initial exemption, granted last spring, is set to expire in March). I would even recommend going further and exempting bank reserves permanently. This would help solve a problem that arises when the Fed buys securities to stimulate the economy: Its purchases cause reserves to increase, bringing banks closer to the point where the leverage ratio requirement binds and forces them to curtail lending. When this happens, it undermines the Fed’s stimulus efforts. To ensure that the exemption wouldn’t reduce the amount of capital required to be held by banks, the leverage ratio and other capital requirements could be adjusted upwards.
Granted, the Fed might have a hard time selling such a move to other financial regulators, which don’t share its monetary policy mandate. But it would be the right thing to do, eliminating the inherent conflict between the Fed’s quantitative easing and bank leverage limits. Under the current regime, the Fed is adding accommodation with one hand, and taking it away with the other. That’s a strange way of doing business.
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Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.