In our last article, QE Is Coming, we focused on why the capital and financial markets have become so dependent on the Fed for liquidity.  The article explains that, in the aftermath of the crisis, a slew of regulations drastically changed the liquidity landscape. As a result, the Fed—not the private market—is now the primary provider of liquidity.

A reader asked us the following:

“Can you provide a list and description of the liquidity tools in the Fed’s toolbox?”  

We like the idea. Given the importance of liquidity to financial market performance, it is crucial to understand not only who supplies liquidity but also how they do so.

Let’s walk through the Fed’s balance sheet and gain a better appreciation for its toolbox.
 

Total Reserve Balances

In our prior article, we noted that overnight liquidity providers have shifted from private markets to the Fed.

Many repo counterparties that provided liquidity in the pre-2008 era were not banks and thus did not hold bank reserves. Today, with many of those liquidity-providing counterparties unable or unwilling to provide liquidity, liquidity comes from the banks via the Fed. When a bank transacts with the Fed, the Fed either adds or withdraws reserves to the banking system. Thus, when assessing the level of outstanding liquidity, a glance at banking system reserves provides a good gauge. Think of reserves as a footprint of Fed actions.

The graph below shows that bank reserves are approaching five-year lows. As a result, and unsurprisingly, the Fed has ended QT, which reduces reserves, and has begun hinting at QE.
 

Given that liquidity in the financial system is now reserves-based, let’s look at the Fed’s tools for adding and reducing reserves.
 

QE/QT

Quantitative Easing (QE) and Quantitative Tightening (QT) are the most well-known of the Fed’s tools.  

QE is when the Fed purchases Treasury and/or Mortgage-Backed Securities from the banking system. The Fed pays the banks for the securities with reserves. Thus, QE removes securities from the market and increases banks’ reserves. QT is the opposite, as it effectively puts securities back into circulation, thereby removing reserves from the banking system. As the chart shows, QE and QT are correlated with bank reserves, but there are clearly other factors — some under the Fed’s control and others beyond the Fed’s reach — that also affect reserves, as we will discuss.
 

QE and QT are blunt liquidity tools, as they regularly inject or withdraw reserves on a fixed schedule, regardless of the system’s daily liquidity requirements.
 

Other Reserve Management Tools

To help the Fed fine-tune the financial system’s daily liquidity demands, it offers several facilities to the capital markets. The rates on these programs are based on the Fed’s target Fed Funds rate. While activity in the Fed Funds market pales in comparison to what it was before the financial crisis, the Fed Funds rate remains the policy rate at which the Fed targets overnight financing.

As the graph below shows, the Fed is incredibly effective at controlling the rate.
 

The Toolbox

The Fed has five primary tools for targeting the Fed Funds rate.

• Interest On Reserve Balances (IORB): The Fed pays interest on banks’ reserves held at the Fed. Raising the rate increases the incentive to hold reserves and vice versa. Therefore, IORB can effectively manage reserves and, in turn, liquidity.
• Open Market Operations: Before 2008, open market operations were the primary tool the Fed used to manage the Fed Funds rate. It entails the Fed buying and selling government securities to withdraw or add liquidity to the money markets. Buying increases reserves and adds liquidity, while selling does the opposite. They are like QE or QT, except they occur on an as-needed basis. These operations are now infrequent.
• Overnight Reverse Repurchase Facility (ON RRP): Through this program, the Fed borrows money from a counterparty via repo.  The program keeps a floor on overnight interest rates. This facility absorbed excess liquidity from the massive Pandemic stimulus. Its daily volume is now minimal.
• Standing Repo Facility (SRF): This facility provides overnight liquidity by lending cash against collateral. Just as the ON RRP is a floor, the SRF is a ceiling. Assuming counterparties are willing to borrow from the Fed, the Fed Funds rate should be capped at the SRF rate.
• The Discount Rate: A relic of the pre-financial crisis era. Like the SRF, it serves as a backstop. The discount rate is above the Fed Funds rate; thus, there is little incentive to use it, other than in times of a severe liquidity shortfall.

The Fed’s tools create a corridor, or floors and ceilings for overnight rates, allowing the Fed to control overnight borrowing rates. The table below shows what the corridor looks like assuming today’s Fed Funds target range of 3.75% to 4.00%.
 

Regulatory Factors Affecting Liquidity

As we discussed extensively in QE Is Coming, a spate of conservative regulations has significantly changed who provides liquidity to the capital markets. There is a lot of talk that these risk-averse regulatory measures could be reversed shortly.

When Chair Powell’s term ends next year, we are likely to see some deregulation in the banking industry, which should improve the private sector’s ability to provide liquidity. Per the Washington Post:

One of the most consequential shifts may come in a highly technical debate over how much debt banks can use to fund their investments and the size of financial buffers that big banks hold to absorb losses. The Federal Reserve and other regulators are planning to ease requirements in ways that could have the effect of increasing the overall amount of debt and lowering the protective cushions in the system. While it remains unclear exactly where officials will land, it’ll be far from the Biden-era effort to essentially do the opposite.

Over the long run, the risks of deregulating the banking industry should be concerning, as history has proven that such actions can be unwise. However, investors should also focus on the short-term benefits.  Specifically, reductions in capital requirements, especially for the largest banks (GSIBs —Globally Systemically Important Banks), would free up capital, allowing them to make more loans and/or buy more securities. Such would result generally in more system-wide liquidity. Additionally, the largest banks should post higher profits and be more incentivized to hold US Treasuries, thereby lowering yields.
 

The Public Sectors’ Impact On Liquidity

The Fed has significant power to manage liquidity, but the free market still dictates its distribution and use. Consider a few ways in which the public sector dictates liquidity.

• Bank Deposits: When a customer deposits money at a bank, they are essentially providing the bank with liquidity. The one deposit allows the bank, through the fractional reserve banking system, to make several loans, which, in aggregate, can be up to 10x the original deposit. Withdrawals have the opposite effect on liquidity.
• Loan Demand: Strong loan demand uses reserves, thus reducing liquidity. Conversely, when the private sector is not demanding loans, reserves tend to be stable.
• Bank Lending Policies: Tight lending policies reduce liquidity from the markets, while easy policies increase liquidity. Lending policies are often a function of system reserves and economic conditions.
• Economic Conditions: Economic conditions tend to play a large role in the demand and supply of liquidity.
• Federal Deficits: Federal deficits require debt issuance, which drains liquidity from the system. The larger the deficit, the more liquidity it demands, which crowds out the private sector.
• Treasury General Account (TGA): The TGA is essentially the government’s checking account, maintained at the Federal Reserve Bank of New York. It includes tax receipts, proceeds from Treasury auctions, and payments distribution.  When the government builds its TGA balances, it drains liquidity from the market. Conversely, when it is declining, liquidity is entering the market.  While an essential part of the liquidity equation and involving the Fed, the Fed staff has no control over the balances.
   

Tracking Liquidity At The Fed 

Every week, the Fed releases its balance sheet and the changes to it from the prior week. The report is linked HERE.

In addition, all the programs discussed in this article can be charted on the St. Louis Fed’s FRED website.
 

Graphing Today’s Liquidity Stress

We now share two graphs to help appreciate the liquidity stress that is slowly brewing in the capital markets. For reference, SOFR, or the secured overnight financing rate, is the overnight borrowing rate for non-bank financial institutions. US Treasury securities collateralize SOFR financing; thus, for all intents and purposes, it is risk-free.
 

SOFR vs IORB

SOFR is the overnight repo rate among non-bank financial institutions. The rate is typically above the ON RRP rate at which institutions can lend to the Fed and below the IORB rate. In ideal liquidity conditions, a bank should decide to lend via the collateralized SOFR markets when the SOFR rate exceeds the IORB rate. When SFOR is above IORB and they don’t, it signals there is a liquidity shortfall or some other reason why banks are unwilling to increase profits without taking on risks. As shown below, SOFR has been steadily trading above IORB since October.
 

Standing Repo Facility Usage

The graph below, courtesy of Bianco Research, shows that the Standing Repo Facility has been used somewhat frequently over the last two months. As we wrote, this is a ceiling of sorts and should be used only when the SOFR market is not functioning properly.
 

Summary

Regardless of how much or little you understand of the Fed’s toolbox, the critical concept from this article and QE Is Coming is that the Fed has much more control over liquidity than it did before 2008. Consequently, given that liquidity is a primary driver of markets, the Fed’s monetary and regulatory actions should be of utmost importance to investors and closely followed.

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