The impact of QT on the Fed’s liabilities and the massive movements between them.
By Wolf Richter for WOLF STREET.
The daily size of the Fed’s overnight reverse repurchase agreements (ON RRPs) fell to $1.40 trillion on Friday. This is a decline of 45% or $1.152 trillion from the one-day wonder peak on December 31, 2022.
Under these RRPs, the Fed accepts cash and issues collateral (Treasury bonds). EIAs represent a liability for the Fed because they are cash that the Fed owes to its counterparties. The counterparties are predominantly US money market funds, but also banks and government-sponsored companies (Federal Home Loan Banks, Fannie Mae, Freddie Mac, etc.). These counterparties use ON RRPs to park their additional cash risk-free with the Fed and earn interest. Starting with the July rate hike, the Fed will pay them 5.3% interest.
This 5.3% is less than the amount the Fed pays banks for their reserve balances (5.4%), so banks don’t use EIAs often. For money market funds (MMFs), ON-RRPs are a good risk-free deal, but they pay slightly less interest than Treasury bills (around 5.5%). And money market funds have withdrawn their money from these EIAs to load up on government bonds.
Which money market funds?
The Fed began paying interest on RRPs in the spring of 2021, then minuscule interest rates, initially 0.05% APR and then 0.1% APR as federal funds rates were close to 0%. This happened because there was so much liquidity in the financial system due to the quantitative easing (QE) that was still ongoing at the time that government bond yields fell into negative territory.
Treasury money market funds, which invest primarily in T-bills, were at risk of these negative returns; They could cause the money market funds to “lose the dollar” if the fund’s net asset value falls below $1, causing a run on the fund, forced sales by the fund, the collapse of a fund, contagion from there, etc .could trigger. etc., you know the financial panic routine. The Fed’s solution was to pay a little interest on the EIAs, and the money market funds flocked there, and with each rate increase starting in March 2022, the Fed paid more on the EIAs.
In addition, money market funds have shifted some of the cash they need for liquidity purposes from their bank accounts to EIAs as banks were paying 0% interest, and even now they are stingy with the interest they pay. This shift from banks to RRPs via the money market funds caused banks’ reserve balances to decline from the end of quantitative easing. More on that in a moment.
The government’s Office of Financial Research publishes the MSRP balances of money market funds every month, unfortunately with a long delay. The last publication was for July 31, when MMF holdings in RRPs had fallen to $1.75 trillion.
The largest MMF providers top the list: Fidelity funds ($508 billion) accounted for approximately 29% of these EIAs; Vanguard’s funds ($172 billion) accounted for 10%; JP Morgan funds accounted for 8.4% ($148 billion); and 7.9% came from BlackRock ($138 billion):
Foreign official RRPs and ON RRPs.
The Fed also offers RRPs for “foreign official” accounts where other central banks can park their dollar cash.
Each week, the Fed’s weekly balance sheet – the most recent was released Thursday afternoon – only shows balances as of Wednesday, not daily balances. So these are balances up to Wednesday, which have not yet captured the decline in RRPs over the last two days.
Official foreign national RRPs fell to $289 billion, a decrease of $94 billion, or 25%, from the peak in January 2023 (green line).
The chart also shows the ON RRPs (red line) as of Thursday’s balance sheet date ($1.546 trillion). Since then, ON MSRPs have fallen by another $145 billion, which is reflected in the daily chart above.
Both combined – ON MSRPs and foreign official MSRPs – are down $803 billion, or 33%, from Wednesday’s weekly peak last September:
Rising/falling reserves and EIAs do not negate the effects of QE/QT. They are part of these effects.
The fact that liabilities (mainly reserves and EIAs) increased at the same rate as assets during quantitative easing did not negate the effects of quantitative easing. And the fact that liabilities fell at the same rate as assets during the QT does not negate the impact of the QT. This is how a balance sheet works – it always remains in “balance”.
Massive shifts in liabilities on the Fed’s balance sheet.
Every balance sheet consists of assets, liabilities and capital, where: Assets = Liabilities + Capital. The Fed’s capital is limited by Congress and changes only slightly. But its assets and liabilities are changing massively.
On the assets side of the balance sheet, QT is progressing at record pace; The Fed has shed $867 billion in assets since its peak, now it’s down to just $8.099 trillion.
On the liabilities and capital side, the Fed has cut $868 billion in liabilities since the April peak, now down to just $8.056 trillion; and it increased its capital by $1 billion to $43 billion.
But there were also massive shifts between liabilities, with some rising and others falling, which we’ll get to in a moment.
The four largest liabilities:
- RRPs (discussed above)
- Reserves
- Cash in circulation (paper dollars)
- Treasury General Account (TGA), the government’s current account.
Reserves: $3.33 trillion, -$940 billion since peak in December 2021. But +$337 billion since the March banking panic.
Reserves are cash that banks deposit with the Fed and provide a form of immediate liquidity in the banking system. Reserves represent a liability on the Fed’s balance sheet because the Fed borrowed this cash from banks. Since raising interest rates in July, the Fed has been paying banks 5.4% interest on their reserve balances.
Banks do not refer to them as “reserves” on their own balance sheets, but rather as “interest-bearing cash” or something similar. They are assets for the banks. They use their reserve accounts at the Fed to transfer cash between banks, transact with the Fed, have cash when needed, and earn 5.4% interest.
Reserves have risen since the banking panic in March, after falling sharply in the previous 15 months.
QT is draining liquidity from the financial system and reserves are one area where the drain has shown up. But the banking panic in March – Silvergate Capital, Silicon Valley Bank, Signature Bank and First Republic collapsed – led banks to increase their liquidity and deposit some of that cash as reserves at the Fed.
QE ended in March 2022. QT began in July 2022. Note the sharp decline in reserves from December 2021 until the banking panic in March 2023, and then cash started flowing back into reserves:
Reserves plus RRP: $5.17 trillion; -$1.01 trillion since peak in December 2021.
Since there are large cash movements between reserves and EIAs via MMFs, it makes conceptual sense to look at them together to see how much liquidity is being withdrawn from the financial system together via QT.
Quantitative easing during the pandemic had increased the total reserves plus ERP by $4.2 trillion to $6.18 trillion as of December 2021.
Since that peak, the total balance of EIAs and reserves has decreased by $1.01 trillion, or 16%, to $5.17 trillion
Cash in circulation fell to $2.33 trillion.
Currency in circulation reflects the paper dollars in wallets, under mattresses and in safes across the United States and around the world. Various studies show that the majority are based abroad.
The amount of currency in circulation is dependent on demand through the U.S. banking system. If customers demand paper dollars, the banking system must have enough paper dollars. Foreign banks have relationships with U.S. banks to raise dollars for their customers.
These “Federal Reserve Notes,” as they are called, are a liability for the Fed. Banks receive these paper dollars from the Fed in exchange for collateral such as Treasury bonds, which are assets on the Fed’s balance sheet.
This is one of the reasons why Fed assets rise when there is no QE and QT: the demand for currencies must be met by banks, and in return, banks must deposit collateral with the Fed for the amounts the assets of the Fed and its assets are rising in part with the increase in cash in circulation.
Before quantitative easing, cash in circulation was the primary driver of the increase in assets on the Fed’s balance sheet through the collateral (Treasury bonds, etc.) that banks must post to receive these paper dollars.
Currencies as a means of payment for legitimate purchases are increasingly being replaced by electronic payment systems (credit cards, debit cards, ACH, Zelle, PayPal, etc.). But during the pandemic, the demand for currencies was enormous. When there is fear of a crisis, the demand for paper dollars increases massively: before the year 2000, after the Lehman bankruptcy and from the beginning of 2020.
Demand for circulating cash has now stabilized as some people return their paper dollars to the bank and then earn 5% interest on their electronic dollars.
Since peaking in early June, cash in circulation has fallen by $14 billion to $2.33 trillion.
Treasury General Account (TGA): $537 billion.
The Treasury Department is unleashing a tsunami of new Treasury bills and bonds to finance federal deficits and increase the balance of the TGA account, the Treasury Department’s checking account at the Fed.
The amount in the TGA account is a liability of the Fed – money that the Fed owes the government.
The Treasury said it plans to end the third quarter with a TGA of $750 billion. September 15th was the date estimated taxes were due. Therefore, these tax receipts will appear in the TGA in the next two weeks and increase the balance. At the time of Thursday’s Fed earnings report, the amount in the TGA was $537 billion.
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