By Daniel Kruger and Kate Davidson 

Budget deficits that are projected to rise for years are straining the plumbing of the U.S. financial system, making it harder for the Federal Reserve to manage the interest rates that influence how much consumers and businesses pay to borrow.

In September, the Fed was forced to intervene in money markets to quell a brief but alarming spike in short-term interest rates. The central bank says it is prepared to handle any funding pressures that might arise before year's end in the $2.2 trillion market for repurchase agreements, or repos. But a longer-term solution remains to be worked out.

The repo market, though little known to the general public, is essential to the smooth functioning of the financial system. Banks depend on it to borrow cash cheaply for short periods, using government bonds as collateral, which in turn ensures a reliable supply of credit to the economy.

In the past two years, the Treasury Department has issued rising volumes of government debt, leaving the firms known as primary dealers -- which buy the securities and sell to other market participants -- with a surfeit of such collateral. This has come as the amount of money available to lend has been shrinking. As a result, too much collateral ends up chasing too little cash. That puts upward pressure on short-term interest rates at times of peak demand, such as the end of the quarter.

With federal budget deficits projected to average $1.2 trillion a year for the next decade, the supply of Treasury debt used as collateral will continue to swell. That is a headache for the Fed, which relies on the repo market to help manage the benchmark federal-funds rate that influences borrowing costs throughout the economy. On Wednesday, the Fed decided to keep the rate in a range of 1.5% and 1.75% and signaled it is in no hurry to raise it.

When the government runs a budget deficit, it relies on borrowed money to fund itself. As deficits accumulate, the supply of new bonds grows by roughly the same amount, adding to the supply of debt used as collateral in the repo market.

"The Fed cannot defend trillion-dollar deficits year after year after year," said Mark MacQueen, a bond manager at Austin, Texas-based Sage Advisory. "That's bigger than they are."

Big budget deficits are nothing new, of course, but they generally widen in times of recession. This time, deficits are growing following the GOP tax cuts and government-spending increases while the economy is expanding. The deficits are likely to get even bigger in a downturn.

Burgeoning deficits coincide with a reduced supply of cash in money markets after the Fed reduced its portfolio of bonds and other assets, to $3.7 trillion in September from $4.5 trillion at its peak in 2015. It currently stands at about $4 trillion.

In mid-September, the growing supply of Treasury bonds used as collateral collided with a sudden shortage of cash. Corporations made quarterly tax payments on the same day investors paid for Treasury debt bought at auction. Meanwhile, banks' reserves -- money they keep at the Fed -- had been falling as the central bank had been unwinding some financial-crisis-era stimulus measures. The result: Overnight rates in the repo market spiked to as high as 10%, and the fed-funds rate rose above the central bank's target range.

The Fed stepped in, offering billions of dollars in overnight cash loans each day starting Sept. 17 to help pull rates down. Separately, the Fed bought Treasury bills to add cash to the economy and increase the amount of bank reserves, a process it plans to continue through the middle of next year.

The volatility in rates and the Fed's response caused alarm because it was reminiscent of the Fed's emergency intervention in money markets during the financial crisis. Fed Chairman Jerome Powell last week said the Fed's efforts to keep short-term rates stable are working and "are not likely to have any macroeconomic implications." The year-end funding pressures appear manageable, he added.

Treasury Secretary Steven Mnuchin recently told lawmakers he was working closely with Mr. Powell to ensure there are ample reserves in the banking system at year's end and was reviewing the role that corporate-tax deadlines and bank regulations played in the September volatility.

Fed officials are also working on a new market mechanism that could make cash available in the repo market to a broader array of firms. Yet few observers expect it to be available soon, because some basic questions are yet to be resolved, including which firms would be eligible to participate. Mr. Powell said Wednesday that establishing such a mechanism would take time, and he emphasized that officials are focused on preparing for the end of the year.

Meanwhile, the existing, improvised lending operation the Fed launched in September may not be enough to hold down repo rates later this month, some analysts say. The reason: Big banks must set aside more money to meet year-end regulatory requirements, which have grown more stringent since the financial crisis. That may prompt them to charge more for repo-market loans no matter how much cash the Fed injects.

"It seems reasonably clear that digesting the increased supply of Treasurys is going to be a continuing challenge," former Fed governor Daniel Tarullo said at a Brookings Institution conference on Dec. 5.

Write to Daniel Kruger at Daniel.Kruger@wsj.com and Kate Davidson at kate.davidson@wsj.com

(END) Dow Jones Newswires

December 15, 2019 10:14 ET (15:14 GMT)

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