The Fed: Watch What I Say, Not What I Do

Does anyone doubt the resolve of the Federal Reserve to maintain an accommodative monetary policy? Monetary stimulus has been a key feature of the stock market’s relentless rise since the depths of the covid crisis, and easy money has almost undoubtedly boosted prices of bonds, commodities, and non-traditional assets as well. I’ll stop short of asserting that modern financial markets are addicted to central bank liquidity, though investors have a near-Pavlovian response to news of fresh monetary stimuli.  

Why then is the Federal Reserve actively draining cash from the banking system? This is evident from the reverse repo activity that has been growing rapidly over recent days. The following graph illustrates that trend:

Reverse Repo Activity at the Federal Reserve

Source: Marketwatch

A general rule of thumb for understanding how the Fed adds or subtracts liquidity from the system is to see whether it is buying or selling securities. Buying securities adds cash to the system. If the Fed is buying securities, it exchanges money for them. That money enters the financial system in the form of cash or cash equivalents. The Fed increased its balance sheet in an unprecedented manner over the past year. Much of that rise was achieved by purchasing Treasury notes in the open market, and that money flowed into the banking system. If the Fed is selling securities, that means that they receive cash in exchange for them. That cash leaves the banking system.

On a short-term basis, the Fed can manage systemic cash flows via the use of repurchase agreements, more commonly known as repos. A repo is a temporary purchase of securities. The Fed buys securities from primary dealers and agrees to sell them back at a predetermined date. It is effectively a short-term loan of cash to the financial system. A reverse repo does the opposite. The Fed sells securities to dealers with an agreement to buy them back at a predetermined date. That temporarily removes cash from the banking system. And that is the activity that is increasing rapidly over recent days.

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Disclosure: The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the ...

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