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The U.S. central bank opened the emergency window for banks this week for the first time since 2008. On Tuesday the Federal Reserve made $53 billion in liquidity available to the banking sector, in an effort to alleviate the turmoil in the Repo market. Interest rates had risen to 10% shortly before because the banks did not have enough liquidity at their disposal. Companies withdrew money from the account to pay taxes, while at the same time a new issuance of government bonds took place. There was a shortage in the money market, which caused interest rates to skyrocket.
The problems were initially explained as an unfortunate coincidence. But it increasingly seems that the banking sector has a fundamental liquidity problem. The Federal Reserve decided to keep the emergency window open for the rest of the week. Also for Wednesday, Thursday and Friday the central bank provided $75 billion in liquidity. With these measures, the central bank is trying to bring short-term interest rates back within the desired range of 1.75% to 2%. This week, the central bank cut its interest rate by 25 basis points.
The liquidity problem in the banking sector seems to come out of nowhere, but there have already been signs visible in the market in recent months. Since April, the effective interest rate has already been higher than the interest rate that the Federal Reserve pays on reserves that banks park with the central bank, the so-called Interest on Excess Reserves (IOER). Normally, banks would arbitrage out that difference, by taking reserves away from the central bank and lending them to other banks at a higher interest rate. The fact that the banks do not do this fully suggests that they are unable to do so or consider the risk too great.
Fed has completely lost control of the rate corridor pic.twitter.com/Ff5JG8VeCa
— zerohedge (@zerohedge) Sep. 18, 2019
What the U.S. central bank can do in this case is make liquidity available in exchange for collateral. In practice, these are US government bonds, because they are considered risk-free in the financial system. The central bank takes these bonds from the banks and provides liquidity in return. The fact that the central bank had to do so for four days in a row this week points to a structural shortage of liquidity.
Several analysts believe that the Federal Reserve played a role in the creation of these problems. In recent years, the central bank has reduced its balance sheet by putting government bonds on the market and removing liquidity from the market. As a result, banks' total excess reserves have returned to the level before the third purchase programme. This may have reached the critical level of reserves that banks need to maintain their liquidity position.
It looks as if the US Money market could no longer function without QE drugs. NY Fed plans to do another $75bn overnight repo op on Fri. It follows liquidity doses of the same size Thur and Wed, and $53.2bn on Tue. (Chart from @Quillintel's @DiMartinoBooth) pic.twitter.com/K9kUlxKUeF
— Holger Zschaepitz (@Schuldensuehner) September 20, 2019
Earlier this year, two Federal Reserve economists wrote about the need to revamp the bond-buying program. Easing. Banks should be given more leeway to exchange government bonds for reserves at the central bank and vice versa. That's exactly what happened this week when the Federal Reserve decided on Tuesday to open the emergency window and keep it open until Friday.
This week's events show that the banking sector still cannot function without central bank support. If this problem persists, the central bank is likely to set up a permanent liquidity window (a so-called Standing Repo Facility) or a new round of quantitative easing. There are already clues that the central bank will discuss this topic at its next meeting in October.
This contribution was made from Geotrendlines
