BOK: "US Short-Term Finance Concentration... QT May Be Difficult to Continue Next Year"

Jerome Powell, Chairman of the U.S. Federal Reserve (Fed), is holding a press conference after concluding the Federal Open Market Committee (FOMC) regular meeting at the Fed headquarters in Washington DC on the 27th of last month (local time). [Image source=Yonhap News]

Since the start of the U.S. interest rate hikes, the Federal Reserve's (Fed) reverse repurchase agreement (RRP) volume has surged, leading to a concentration phenomenon in the short-term financial market, according to an investigation. The Bank of Korea explained that this phenomenon could excessively reduce market liquidity, making it difficult for the Fed to continue quantitative tightening (QT) in the future.

According to a report titled "Short-term U.S. Financial Market Concentration Phenomenon and Implications for QT after Interest Rate Hikes," released by the Bank of Korea's foreign exchange management office on the 3rd, RRP balances have rapidly increased since last April, reaching the limit per trading institution, as RRP transactions with the Fed have increased instead of short-term Treasury bills (T-bills) issued by the U.S. Treasury.

This is because the U.S. government reduced the issuance of T-bills, and due to increased market volatility and heightened risk aversion, demand for T-bills has risen. As of the 29th of last month, the 1-month T-bill rate was 2.15%, while the Fed's RRP rate was higher at 2.30%. The Bank of Korea explained, "Due to the interest rate merit of RRP, non-bank financial institutions such as money market funds (MMFs) are expanding RRP transactions with the Fed instead of purchasing T-bills."

When the Fed's RRP increases, the size of bank reserves (required reserves) decreases accordingly. This is because when MMFs and others purchase bonds from the Fed under repurchase agreements, the purchase funds are immediately transferred to the Fed's RRP account. In fact, during the period from April to July, when T-bill rates and RRP rates were inverted, RRP increased by $400 billion, while bank reserves decreased by $500 billion.

The Bank of Korea explained that the cash flow from these RRP transactions is similar to the cash flow when the Fed conducts QT. QT reduces liquidity in the financial system by changing the bond holders from the Fed to other entities, and RRP also absorbs market liquidity by selling bonds with repurchase conditions to the Fed.

The Bank of Korea pointed out that currently, due to excessive excess liquidity, the burden is not significant even if QT starts and RRP increases, but in the future, market liquidity could decrease more than the appropriate level desired by the Fed, so the possibility that the Fed may find it difficult to continue QT cannot be ruled out.

Global investment banks (IBs) have expressed similar views. Barclays forecasted that despite the Fed's large excess reserves, the size of bank reserves is rapidly shrinking due to QT implementation and RRP increases, and the Fed may consider reducing the scale of QT as early as the beginning of next year. Sweden's financial company SEB also warned that bank reserves could fall below the Fed's recommended level in the second half of next year, potentially increasing short-term financial market volatility due to reserve shortages, similar to the situation in 2019.

This content was produced with the assistance of AI translation services.