Dallas Fed president Lorie Logan delivered remarks at the annual meetings of the International Banking, Economics and Finance Association and the American Economic Association. She discussed the Fed’s balance sheet and implementation of policy in money markets.
“Looking across the financial system as a whole, we’re still seeing tightening from bank credit and refinancing of term corporate debt. But a lot of the effects of higher rates are already behind us, and the recent easing in conditions could start to push up on aggregate demand.
“Turning to the Fed’s balance sheet and policy implementation, we have reduced our securities holdings since mid-2022 at a brisk pace consistent with the principles and plans that the FOMC announced earlier that year. While securities holdings have declined by $1.3 trillion, bank reserve balances have actually risen by $350 billion dollars to around $3.5 trillion. That’s because reduced balances in the Federal Reserve’s overnight reverse repurchase agreement (ON RRP) facility have more than offset the decline in securities holdings. Increased Treasury issuance and a less uncertain interest rate path have contributed to the rapid ON RRP runoff by motivating money market funds to invest more in Treasury bills.
“Money markets and policy implementation are continuing to function smoothly. As we did in 2018 and early 2019, we are likely to see modest, temporary rate pressures as our balance sheet shrinks and our liabilities redistribute. These rate pressures can be a price signal that helps market participants redistribute liquidity to the places where it’s needed. Experience shows that these pressures tend to emerge first on dates when liquidity is unusually encumbered or is draining out of the system especially rapidly, like tax-payment dates, Treasury settlements and month-ends. And indeed, we saw small, temporary rises in the Secured Overnight Financing Rate (SOFR) over the November–December and year-end turns. But on nearly all days, broad money market rates have remained well below the interest rate on reserves.
“The emergence of typical month-end pressures suggests we’re no longer in a regime where liquidity is super abundant and always in excess supply for everyone. In the aggregate, though, as rate conditions demonstrate, the financial system almost certainly still has more than ample bank reserves and more than ample liquidity overall. The most recent Senior Financial Officer Survey shows that most banks in the sample have reserves well in excess of their lowest comfortable levels and desired buffers. ON RRP balances remain around $700 billion. And the Federal Reserve’s Standing Repo Facility (SRF) provides a backstop against any unexpected pressures.
“Still, individual banks can approach scarcity before the system as a whole. In this environment, the system needs to redistribute liquidity from the institutions that happen to have it to those that need it most. The faster our balance sheet shrinks, the faster that redistribution needs to happen. I’d note that the current pace of asset runoff is around twice what it was in the first half of 2019. And while the current level of ON RRP balances provides comfort that liquidity is ample in aggregate, there will be more uncertainty about aggregate liquidity conditions as ON RRP balances approach zero.
“So, given the rapid decline of the ON RRP, I think it’s appropriate to consider the parameters that will guide a decision to slow the runoff of our assets. In my view, we should slow the pace of runoff as ON RRP balances approach a low level. Normalizing the balance sheet more slowly can actually help get to a more efficient balance sheet in the long run by smoothing redistribution and reducing the likelihood that we’d have to stop prematurely.
“Lastly, I want to take note of the Securities and Exchange Commission’s adoption last month of a requirement for broader central clearing for cash and repo transactions in the Treasury market. While broader central clearing won’t cure all of the market’s vulnerabilities, our research at the Dallas Fed finds that it will have significant benefits. Related to my previous comments, broader central clearing should make repo markets more elastic as multilateral netting can reduce intermediaries’ balance sheet costs.
“That will help smooth the redistribution of liquidity when balance sheets are constrained, such as during stress episodes and at period ends. Broader central clearing should also meaningfully improve risk management, in particular by mitigating risks at interdealer brokers in the cash market and by addressing the 74 percent of noncentrally cleared bilateral repos that are currently transacted with zero haircuts. Of course, careful implementation by the industry and regulators will be important. The SEC has established a phased timeline, with full compliance in 2026. As the market moves toward broader clearing, I think the FOMC should also consider the benefits of central clearing of the Federal Reserve’s own Treasury market operations. The SEC regulation exempts central banks, but in my view, it’s typically most efficient and effective for us to operate in the same way as the main market participants. And, as I’ve discussed previously, central clearing of the SRF could make that facility more effective in providing backstop liquidity to the broad market.”