Federal Reserve Likely to Adjust Cash Management Strategies

By Michael S. Derby

NEW YORK (Reuters) – The Federal Reserve appears poised to adjust its cash management strategies in a pivotal move expected on Wednesday, as it enters a time of increased uncertainty in what many anticipate to be the final months of its balance sheet reduction effort.

Economists broadly expect the Fed to lower the rate it pays to money market funds and others for parking cash at its overnight reverse repo facility (ONRRP) by a larger margin than the anticipated reduction in its policy rate. The federal funds rate is projected to decrease by a quarter-percentage-point to a range of 4.25% to 4.50%. Conversely, the reverse repo rate is expected to drop to 4.25% from the current 4.55%.

Previously, the Fed adjusted the rate differential between fed funds and ONRRP to manage the funds rate or navigate periods of near-zero rates. Analysts argue that harmonizing the spread now could provide the central bank with greater flexibility as it continues to reduce its bond holdings, a process known as quantitative tightening (QT).

Patricia Zobel, a former manager of the New York Fed's monetary policy team and current head of macroeconomic research at Guggenheim Investments, noted, “It makes sense to me that the [Federal Open Market] Committee would want to return the overnight RRP offer rate to the bottom of the target range.” She believes this change will encourage more alternatives to parking cash at the Fed and potentially lower money market rates.

The Fed’s reverse repo rate aims to establish a soft floor for short-term interest rates. Along with the rates paid to banks for reserves, it helps maintain the Fed's policy rate within its target range.

Usage of the reverse repo facility surged from near-zero in spring 2021 to a peak of $2.6 trillion by the end of 2022. As part of QT, the Fed has reduced its balance sheet from a record $9 trillion in mid-2022 to $7 trillion, allowing some Treasury and mortgage-backed securities holdings to expire without replacement. However, ONRRP usage has remained stable, and levels have yet to dip below $100 billion.

Fed officials have expressed a desire for ONRRP to return to negligible levels, crucial for advancing QT. Reducing reliance on the reverse repo facility suggests that excess liquidity is being removed, paving the way for a decrease in bank reserves.

Derek Tang, an analyst at LH Meyer, remarked, “Active usage of the ONRRP facility was always supposed to be temporary,” adding that its prolonged utilization has turned into a new reality. Some industry experts believe the Fed's role as a “provider of safe assets to the money fund industry” was unintentional, signaling a shift in the central bank’s priorities.

However, observers point out that simply making the reverse repo facility less attractive may not be sufficient, as some larger money funds find it challenging to invest cash elsewhere. Gennadiy Goldberg, head of U.S. rates strategy at TD Securities, explained that the facility offers liquidity and ease of access, especially when late-day inflows occur. Consequently, lowering the RRP rate may only slightly reduce cash within the facility.

The Fed anticipates facing challenges in diminishing ONRRP cash holdings, especially with a potential reintroduction of the government debt ceiling next year. According to the meeting minutes from the Fed's November session, significant shifts in government cash management practices could obscure the ongoing balance sheet runoff effects on money market conditions.

Ahead of the November meeting, surveyed banks projected QT to conclude in May, with the Fed likely to maintain its balance sheet around $6.4 trillion. While market analysts speculate on a possible ONRRP adjustment during the upcoming Wednesday meeting, some expect the Fed to delay any movements until January, aligning it with a meeting where the fed funds rate remains unchanged.

Regardless of the immediate outcome, analysts predict continued volatility in money markets in the coming weeks, complicating the forecasting of QT's conclusion. Quarterly end uncertainties are expected to elevate ONRRP activity while also directing cash to the Fed’s standing repo facility, though this is viewed as a temporary shift with limited long-term implications on QT’s trajectory.