(Bloomberg) -- The US banking system's reserves, a key factor in the Federal Reserve's decision to keep shrinking its balance sheet, tumbled for the seventh straight week to below $3 trillion as liquidity continues to drain from the financial system.
Bank reserves fell by about $21 billion to $2,999.7 trillion in the week through Sept. 24, according to Fed data released on Thursday. That's the lowest level since the week through Jan. 1.
The drop comes as the Treasury has ramped up debt issuance to rebuild its cash balance following the increase in the debt ceiling in July. That drains liquidity from other liabilities on the Fed's ledger, like the central bank's overnight reverse repurchase agreement facility and bank reserves.
But with the so-called RRP nearly empty, commercial bank reserves held with the Fed have been dropping. Cash assets held by foreign banks have declined at an even faster pace than those by their US counterparts.
The shifts in cash affect the day-to-day operations in the financial system as the Fed continues unwinding its balance sheet, a process known as quantitative tightening or QT. As QT may exacerbate liquidity constraints and lead to market turbulence, the Fed earlier this year slowed the pace by reducing the amount of bond holdings it lets roll off every month.
Fed Chair Jerome Powell said last week bank reserve balances are still in abundant conditions and he expects the runoff to when reserves reach an ample level, though they're getting closer. However, signs in the financial system suggest that the central bank may be getting closer to that amount, pressuring the Fed to end its balance-sheet runoff sooner than expected.
Because of these changes in liquidity, the effective federal funds rate — the central bank's policy target — edged higher within the range this week, an indication of tighter financial conditions ahead. The rate rose one basis point to 4.09% from 4.08% the prior session, New York Fed data released Tuesday showed. It remains inside the Federal Open Market Committee's 4% to 4.25% band, set last week when policymakers cut borrowing costs. For the past two years, the metric has been stuck near the lower end of the range.
Once a robust avenue for overnight interbank lending, the fed funds market used to signal when financing conditions were tightening. But massive monetary stimulus during the financial crisis and the pandemic left the country's banking system awash in dollars, leading banks to largely withdraw from the fed funds market and park their money directly at the Fed instead.
Transactions underlying the fed funds rate have declined since there's less surplus money for non-US institutions to deploy in the market, according to Wrightson ICAP senior economist Lou Crandall. In addition, tighter liquidity has caused a recalibration in the weighted distribution of the unsecured funding rate.
Dallas President Fed Lorie Logan said on Thursday the US central bank should abandon the federal funds rate as its benchmark in implementing monetary policy, and consider an overnight rate tied to the more robust market for loans collateralized by US Treasuries.
Logan argued the fed funds target is outdated, and connections between the little-used interbank market and overnight money markets are fragile and could break suddenly. Updating the mechanisms by which the Fed implements monetary policy would be part of efficient and effective central banking, she said.
More stories like this are available on bloomberg.com
