No, we’re not talking about the waistband on your sweatpants, but rather the tongue-twister of:
If the Fed quantitatively tightens, and no bank misses the funds, does that mean the Fed can keep tightening?
The short answer is yes, and let’s unpack that just a tad more, shall we?
A bank holds reserves for liquidity reasons. In fact, it is obligated to hold enough high-quality liquid assets (HQLA) to withstand a 30-day stress period. Those are the rules.
Should those reserves not be enough—for example during a bank run—the bank can borrow short-term liquidity from other banks or the Fed.
As this need to borrow in a crisis can arise pretty quickly it is important for the Fed to have enough funds around. As an example, the Fed expanded their funds significantly from mid-2020 through the end of 2021. That is called quantitative easing (QE) and is one of the greatest hits of monetary policy.
But too many funds in the system are counterproductive when the Fed is trying to keep interest rates high to make inflation go low. So, since 2022, the Fed has shrunk its balance sheet (a lot) by letting securities mature without replacing them. That is called quantitative tightening (QT).
But when is enough enough?
This week the Fed dropped a new metric, Reserve Demand Elasticity (RDE), to figure that out. RDE incorporates data about Fed funds transactions, interbank transactions, and bank reserves and assets, and measures—in close to real time—how sensitive the price of liquid funds (the Fed funds rate) is to the volume of funds.
If the price changes in either direction with the volume, that is a sign that the volume is close to being just right. If the price does not change with the volume, that is a sign that no one would care if a bit more went away.
And that’s where we are right now. The very first release of the RDE shows a 50th percentile value of -0.06 which the Fed calls “indistinguishable from zero”.
In other words, the banks are plenty flush with reserves themselves—about $3.2 trillion—to need any funds from the Fed. That’s a good thing, right?!?
That depends. It is good in the sense that the Fed didn’t shrink too far. It is also good that the banks are safe and well-cushioned.
It does, however, slightly undermine Team Regulator’s default stance that banks should hold more reserves.
And with the yield curve reverting back to its normal upward sloping it will be less attractive for Team Bank to hold the short-term (liquid) assets, and the reserves might snap back with elasticity.
Regitze Ladekarl, FRM, is FRG’s Director of Company Intelligence. She has 25-plus years of experience where finance meets technology.
This article is part of the FRG Risk Report, published weekly on the FRG blog. To read other entries of the Risk Report, visit frgrisk.com/category/risk-report/.