A Fed Adjustment Could Be Made This Week to Drain Liquidity Into Next Year

On Wednesday, the Federal Reserve will dominate headlines with its anticipated decision to cut its benchmark federal funds rate for the third consecutive meeting. Market participants widely expect a 25-basis-point reduction, bringing the target range to 4.25%-4.5%. However, another significant move could emerge—a technical adjustment to the rate tied to Wall Street's financial plumbing.

‍

Many Fed analysts anticipate that the central bank will lower the interest rate investors earn through its reverse repurchase (reverse repo) facility by an additional 0.5 basis points. This adjustment would bring the reverse repo rate down to 4.25%, aligning it with the bottom of the federal funds target range. This tweak reflects a continued effort by the Fed to refine its monetary tools. During the pandemic, the Fed implemented a 0.5-basis-point gap between the lower range and the reverse repo rate to prevent rates from falling into negative territory amid financial instability.

‍

Matthew Luzzetti, chief U.S. economist at Deutsche Bank, sees the adjustment as part of the Fed’s strategy to avoid a repeat of the funding market stress experienced in September 2019. Back then, a liquidity shortage caused a sudden spike in short-term funding rates, forcing the Fed to intervene by increasing its balance sheet.

‍

“The Fed is exploring how best to set its various rates and when it might be appropriate to slow or stop quantitative tightening (QT) to prevent shocks to funding costs,” Luzzetti explained. QT refers to the process of shrinking the Fed’s balance sheet, which it resumed in mid-2022 after years of pandemic-induced expansion. Since its peak of nearly $9 trillion, the balance sheet has been reduced to just under $7 trillion.

‍

John Canavan, lead analyst at Oxford Economics, noted that lowering the reverse repo rate could ease pressure on overnight funding rates, which have been strained in the latter half of this year. This adjustment could allow the Fed to continue its QT program into the first quarter of 2025 without disrupting market liquidity.

‍

Despite this technical adjustment, Luzzetti emphasized that the move wouldn’t alter overall liquidity in the financial system. Instead, it’s designed to encourage a shift of money from the reverse repo facility to bank reserves, potentially alleviating funding pressures tied to year-end financial activities.

‍

The Fed’s ultimate goal is to transition bank reserves from what it considers “abundant” to a more balanced “ample” level. Determining the exact point to halt QT remains challenging, but the central bank has already slowed the pace of its balance sheet reduction significantly. Currently, only $25 billion in Treasurys are allowed to roll off the balance sheet each month.

‍

Dallas Fed President Lorie Logan likened the slowing QT process to a ferry carefully decelerating to assess when to dock. This metaphor highlights the Fed's cautious approach to managing liquidity levels in the banking system as it approaches critical thresholds.

‍

The possibility of an adjustment to the reverse repo rate was first raised during the Fed’s November meeting, as noted in minutes released last month. Analysts widely interpret this discussion as an indicator that the change could be implemented as early as Wednesday.

‍

Thomas Simons, an economist at Jefferies, pointed out that the Fed has historically acted on such discussions at the following meeting. “Given the precedent, we anticipate that the Fed will make the adjustment this time,” Simons stated.

‍

However, not all analysts agree on the timing. Lou Crandall, chief economist at Wrightson ICAP, suggested that the Fed might opt to delay the adjustment until January. This staggered approach would separate the decision on the reverse repo rate from the broader policy rate decision, potentially avoiding confusion among market participants.

‍

The Federal Reserve’s decisions this week represent a delicate balancing act. While the anticipated rate cut aims to address broader economic considerations, the technical tweak to the reverse repo rate is more narrowly focused on fine-tuning the mechanics of financial markets. By draining funds from the reverse repo facility into bank reserves, the Fed hopes to ensure smoother market operations and avoid liquidity shocks similar to those seen in the past.

‍

These moves also underscore the Fed’s flexibility in managing QT. After aggressively reducing its balance sheet earlier in the program, the Fed now proceeds cautiously, signaling its intention to adjust pace and tools as necessary. The central bank's ability to maintain market stability while normalizing monetary policy will be closely watched as it navigates these complex dynamics heading into 2025.

‍