As market rates increased along with Fed hikes, the dollars in the RRP flowed back into the market to earn a positive return. The RRP was used from the end of the post-GFC QE cycle in 2013 until the Fed began to raise interest rates and shrink the balance sheet in 2017. It didn’t pay interest, but no interest is better than negative yield. This was an overflow facility that mopped up the excess liquidity. The Reverse Repo Facility was a tool that allowed the market to give dollars back to the Fed, rather than buy negative yielding debt. At some point, it injects so much cash that short-term interest rates go negative. When injecting liquidity via QE, the Fed has little idea how much is too much. The trouble with liquidity policy, like playing an oboe with a leaf blower 3, is that it’s really tough to find the right volume and pitch, particularly if you’ve never played the oboe, and are conducting an orchestra at the same time. Now embarrassed and headstrong to tackle rampant inflation, the Fed seems likely to repeat its mistakes. Pessimistically, the Fed failed its one previous attempt at liquidity tightening. Optimistically, the Fed may not be as far behind the curve on taming money growth as many think. Though the Fed has only just begun reducing the size of its balance sheet, market liquidity crested in late 2021 and has been on a sharp decline since, thanks to other critical changes in the Fed’s policies. The Fed’s balance sheet shrinks.īut the size of the Fed’s balance sheet is not the only factor that influences market liquidity and is insufficient to understand liquidity conditions in practice. To reduce liquidity, the Fed allows the bonds it bought to mature without reinvesting the proceeds, removing those dollars from the system (“Quantitative Tightening” or “QT”). In the process, the Fed’s balance sheet expands. To create liquidity, the Fed purchases bonds from the public in exchange for newly created dollars (“Quantitative Easing” or “QE”). With liquidity policy, the Fed grabs an oboe and plays it with a leaf blower.ĭirectly influencing public market liquidity is now a key policy tool of the Fed. With interest rate policy, the Fed conducts an orchestra, guiding the musicians with its baton. The original QE was a wartime measure - the first large scale use of liquidity as a policy tool - but wartime measures have a way of sticking around. To save the financial system in 2008, the Fed directly intervened in the US Treasury (“UST”) and Mortgage-Backed Security (“MBS”) markets to stabilize prices and inject much needed liquidity into an over-levered banking sector. The Fed uses short-term interest rates to encourage or discourage credit creation and money supply. The Federal Reserve has two tools to implement its monetary policy, one old and one new. Quantitative Tightening did not begin this month.
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