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Fed Mulls Lessons of Money-Market Spike After Curbing Volatility


Federal Reserve officials are studying whether market plumbing issues contributed to a spike in short-term lending rates this week, after the central bank said it would extend recent operations to inject cash into money markets.

Investors this week have highlighted declines in bank deposits held at the Fed, known as reserves, as a driver of this week’s funding volatility. But New York Fed officials said Friday they were also examining whether the distribution of those reserves across the banking system—and not just the absolute level—had contributed to cash shortages earlier this week.

“That ability of the system to move money around and redistribute—it didn’t work the way we’ve seen in the past,” said New York Fed President

John Williams

in an interview on Friday.

The New York Fed said on Friday it would continue to offer to add at least $75 billion daily to the financial system through Oct. 10, prolonging its efforts to relieve pressure in money markets.

In addition to at least $75 billion in overnight loans, the Fed said it would also offer three separate 14-day cash loans of at least $30 billion each next week. The Fed will conduct further operations as needed after Oct. 10.

“This is, I would say, Central Banking 101,” said Mr. Williams. “This is what the Fed’s open-market operations are designed to address—directly provide liquidity into the system, which supports market functioning.”

On Monday, corporate tax payments were due to the Treasury, and Treasury debt auctions settled, leading to large transfers of cash from the banking system.

The level of reserves in the system at the beginning of the week appeared “above what we thought banks’ minimum level of reserves was,” said Lorie Logan, a New York Fed executive who is one of the top officials responsible for managing the portfolio.

But those reserves can be concentrated in a few institutions, and officials weren’t sure “what the distribution process would look like as different shocks like this take place and how those reserves would then redistribute to other entities that needed liquidity,” she said.

One of the lessons this week was that this distribution process “was definitely stickier than we expected,” and repo markets experienced greater dysfunction than anticipated as a result, she said.

The Fed is adding money to the financial system through the market for repurchase agreements, or repo. In those transactions, banks offer collateral such as government bonds in exchange for short-term loans, for periods as brief as overnight. The market is a major way that banks and financial firms raise capital to fund their businesses.

The Fed should have been more alert to the potential risks in the repo market, said

Seth Carpenter,

chief U.S. economist at UBS and a former Fed staffer. He said the firm’s traders had first picked up signs markets could face stress as repo rates began ticking higher late last week.

But the Fed restored confidence, particularly through its decision Friday to offer two-week cash loans. “Everybody saw that as their bazooka,” Mr. Carpenter said.

The newly scheduled operations give financial markets an assurance that the Fed will continue adding liquidity through the end of the coming quarter. Banks tend to hold on to cash at the ends of quarters because that is when regulators typically examine their balance sheets to ensure they are following rules that safeguard the banking system.

“It doesn’t take a lot of cash to right the system,” said Glenn Havlicek, the chief executive at GLMX, which provides technology to repo trading desks, and who formerly oversaw the repo desk at

JPMorgan Chase

& Co.

The timing is also important because there have been periods in the past year when demand for cash has exceeded the ability or willingness of investors to provide it, leading to spikes in the rates investors charge banks in repo.

That happened at the end of last year when the repo rate traded as high as 6%, pushing the Depository Trust & Clearing Corp.’s GCF Repo Index to a then-record 5.14%. Repo rates also notably rose in April when people withdrew cash from the banking system to pay federal income taxes.

Separately, the rate-setting Federal Open Market Committee lowered its benchmark federal-funds rate by a quarter percentage point on Wednesday to a range between 1.75% and 2%.

As a result of volatility in the repo market, the fed-funds rate spiked to trade outside of its range on Tuesday, but by Thursday was again trading firmly within the target band.

Mr. Williams said the central bank had effectively diagnosed and deployed its tools to take “forceful, decisive action that addressed the problem,” he said. “We are consistently and constructively supporting stability in these markets, and supporting the FOMC’s desired interest rate.”

On Friday, banks asked for $75.55 billion in reserves, $550 million more than the amount offered by the Fed, offering collateral in the form of Treasury and mortgage securities.

The Fed’s operation was the fourth time this week it has intervened to calm roiled money markets. Rates on short-term repos briefly rose to nearly 10% earlier this week as financial firms looked for overnight funding. The actions marked the first time since the financial crisis that the Fed had taken such measures.

The New York Fed hasn’t had to intervene in money markets since 2008 because during and after the financial crisis, the Fed flooded the financial system with reserves. It did this by buying hundreds of billions of dollars of long-term securities to spur growth after cutting interest rates to nearly zero.

Reserves over the last five years have been declining, especially over the last two years, when the Fed began shrinking securities holdings. Reserves fell to less than $1.4 trillion this week from a peak of $2.8 trillion in 2014.

The Fed stopped shrinking its asset holdings last month. But because other Fed liabilities such as currency in circulation and the Treasury’s general financing account are rising, reserves are likely to grind lower in the weeks and months ahead.

Write to Daniel Kruger at Daniel.Kruger@wsj.com and Nick Timiraos at nick.timiraos@wsj.com

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