$2trn is sitting at the Fed doing nothing

Every morning across the US banking system, an astonishing sum of capital moves through a financial cul-de-sac: approximately $2.2 trillion in institutional cash is deposited at the Federal Reserve’s overnight reverse repurchase facility (ON RRP). For this cash, government money market funds earn an unencumbered, annualized yield of 3.80 per cent directly from the central bank’s balance sheet. To retail observers, this facility looks like an arcane detail of central bank accounting. To institutional treasurers and bank risk officers, it represents an immense balance-sheet dam, preventing trillions of dollars in liquid capital from circulating through the private real economy.

The irony of this liquidity accumulation is profound. Throughout 2022, the Federal Reserve has engaged in aggressive quantitative tightening, allowing up to $95 billion in sovereign and mortgage debt to roll off its balance sheet each month in a bid to drain excess money from the financial system. Yet rather than draining bank reserves, quantitative tightening has left commercial bank deposits exposed to a relentless drain, while the reverse repo facility remains essentially untouched near all-time highs. Trillions of dollars of liquidity are sitting parked at the central bank, collecting risk-free yield while private credit markets face a tightening squeeze.

The Money Fund Magnet

The mechanics that drive cash into the reverse repo facility are the direct result of a yawning rate spread between commercial banks and prime money market funds. Throughout 2022, traditional commercial banks have been exceptionally slow to raise their deposit rates. Constrained by sluggish loan demand and sitting on substantial legacy liquidity, commercial banks have kept their average retail deposit rates pinned near zero, producing historically low deposit betas. Depositors seeking yield have responded with their feet, pulling hundreds of billions from commercial checking accounts and reallocating it into government money market mutual funds.

These money market funds, however, face strict regulatory mandates under post-crisis liquidity rules. They can invest only in short-term government paper: Treasury bills, agency discount notes, and sovereign repo. But because the US Treasury has sharply reduced its net issuance of short-dated Treasury bills over the past year, preferring to fund its deficit via longer-dated coupons, money funds have faced a severe scarcity of private sovereign collateral. The Fed’s ON RRP facility stepped into this supply vacuum, offering an unlimited, risk-free investment outlet paying five basis points above the lower bound of the fed funds target range.

The Reserve Drain Dilemma

The unintended systemic consequence of this setup is that the reverse repo facility acts as a persistent drain on commercial bank reserves. In theory, the Federal Reserve hoped that quantitative tightening would be absorbed primarily by money market funds drawing down their ON RRP balances to purchase the new Treasury securities issued to replace maturing debt. In reality, because money fund yields at the RRP remain highly competitive with short Treasury bills, money funds have had no incentive to shift capital back into the market.

Instead, as the central bank’s balance sheet contracts, the reduction in assets has been matched on the liability side by a direct depletion of commercial bank reserve balances, which have tumbled from over $4.2 trillion in late 2021 to below $3.1 trillion today. If bank reserves continue to decline at this pace while the RRP facility remains pegged above two trillion dollars, the banking system will encounter reserve scarcity far sooner than policymakers anticipated, potentially triggering the same repo market volatility experienced in September 2019.

The $2.2 trillion sitting at the Fed is not benign collateral; it is a structural symptom of monetary plumbing distortion. By offering a risk-free, highly remunerative liquidity sink to non-bank financial intermediaries, the Federal Reserve has created a persistent cash trap that accelerates the drain on commercial bank reserves while sterilising trillions in private market capital. Until the central bank recalibrates the relative pricing of the reverse repo facility, quantitative tightening will continue to bite bank balance sheets in the most disruptive manner possible.