Fed's Control Over Rates Tested by Growing U.S. Budget Deficits
December 15 2019 - 10:29AM
Dow Jones News
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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