America's ad hoc financial system is full of unintended consequences, such as the Fed's increasing liquidity by $1 trillion while trying to quell inflation. How can the stock market be soaring to repeated new highs when the Federal Reserve is trying to constrain the economy? In the last year, as it was trying to restrain inflation, the Fed unintentionally enabled nearly $1 trillion of liquidity to flow into the financial markets, boosting stocks, other risk assets, and, quite possibly, the economy.
The current U.S. monetary system is the result of a series of ad hoc innovations implemented in response to the great financial and pandemic crises. It's been given the veneer of a framework, following which further adhocracies were implemented, leaving the entire structure and most of its key components untested over the long-term and thus rendering it difficult for forecasters including the Fed to anticipate its next consequences. The most recent such consequence is this $1 trillion release of liquidity.
This will end. Because of its unprecedented nature, we can't be sure how, but it may be unpleasant for investors and the economy.
The nexus of these financial flows is the intersection of quantitative easing and tightening with something called reverse-repo transactions, a deposit account in which the Fed sells securities while agreeing to repurchase them at a specific date in the future. Readers are familiar with quantitative easing (QE), where the Fed increases liquidity in the financial markets by issuing cash to buy federal-government securities, and with quantitative tightening (QT), which decreases liquidity with the reverse transaction, receiving cash from securities sold or matured. In contrast, reverse repos are financed with banks' reserves at the Fed, thus decreasing them, which is important because these accounts form the core of liquidity for the U.S. financial system.
Reverse repos have been around for years. Until recently they were only available to banks in the Federal Reserve system, but, as interest rates change following the pandemic, the Fed opened them to non-Fed members such as government housing agencies whose large cash balances distorted short-term interest rates the Fed was targeting. Usage grew from nothing in March 2021, before access widened, to over $2.3 trillion – nearly 10 percent of GDP – in September 2022. Even for the Fed, then holding a balance sheet of 36 percent of GDP, this was a significant amount. Reverse repos are now shrinking back towards zero, as market interest rates change. Since access to them was broadened, the liquidity effect of sustained reverse-repo balances has affected financial markets, as reflected in the following chart comparing reverse-repo balances with U.S. equities.
It has been well-established that the growth of central-bank balance sheets under quantitative easing boosted equity markets. This effect is evident in the chart through 2021. Once reverse repos opened up in March 2021, though, while the Fed's assets kept growing, the surge of reverse repos outweighed QE. Liquidity decreased, and the stock market fell 25 percent. More recently, as earlier noted, a drawdown of reverse repos generated a flood of liquidity that offset the Fed's quantitative tightening by nearly $1 trillion, and the stock market boomed.
The stock market is supposedly not a focus for Fed policy, although that may not always be the case. The Chicago Fed produces an index of financial conditions, a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets and the traditional and 'shadow' banking systems that is believed to reflect the impact of financial markets on the real economy. The following chart compares the Fed balance sheet net of reverse repos with the financial-conditions index.
The financial-conditions index closely tracks the net Fed balance sheet. Index looseness peaks in June 2021, as reverse repos kick in significantly, and index tightness doesn't bottom out until May 2023, when reverse repos began to unwind.
Of note, the effect of reverse repos often offsets expressly articulated Fed policy! From March 2021 to May 2022, the Fed continued QE, but growing reverse repos offset this action by $2 trillion. Recently, QT has been offset by the nearly $2 trillion reverse-repo drawdown. These mismatches between stated policy and actual effect are reflected in financial conditions moving in the opposite of the desired direction.
The mismatches arise from the Fed's failure to synchronize its balance-sheet and interest-rate policies. Many Fed representatives talk about the two policies as if they are entirely distinct, yet the Fed's own research established the direct connection between its balance sheet and market interest rates. To relieve balance-sheet–interest-rate imbalances, the markets have been pushing back into reverse repos the Fed's excessive QE shoved onto them. How interest imbalances drive reverse repos is displayed in the following chart which compares repos with the difference between the Fed's policy rate and the market rate for a comparable investment, one-month T-bills.
When the policy rate exceeds the T-bill market rate, funds flow into reverse repos. When market rates exceed the policy rate, reverse repos wind down.
Clearly, the Fed's adhocracy has developed too many moving parts to manage.
In the long term, the Fed's next framework should rely on successful, simpler, proven procedures from the Great Moderation. In the short term, the Fed should neutralize conflicting components on its own balance sheet. Reverse repos are 80 percent reduced. The Fed should make it 100 percent by providing these balance holders with equivalent U.S. Treasury securities. It should do so now, rather than waiting for shifts in the markets to stabilize the balance sheet.
This would leave the balance-sheet focus entirely on QT and its effects. For all the Fed's past QT – $1.5 trillion in the last two years and $700 billion in 2018–19 – QT has never been implemented without a major offset of central-bank liquidity elsewhere, whether that be the Fed's reverse repos recently or about $500 billion of QE in 2018–9 from the Bank of Japan and the European Central Bank. Unbuffered, QE may have a negative effect upon markets, and Dallas Fed president Lorie Logan's proposal to slow QT's pace is a step in the right direction that may be adopted. Nevertheless, it leaves the prospective risk of significant amounts of unbuffered QT. The best solution is to swap excess reserves for Treasury issues outside the markets to eliminate the overhang while easing financial-market uncertainty and pressure.
The Fed has time-tested, simple, effective procedures for running its monetary policy. It should use them.
Douglas Carr is a financial-markets and macroeconomics researcher. He has been a think-tank fellow, professor, executive, and investment banker.