QE by another name?

Eight days after quantitative tightening officially ended on 1 December, the Federal Reserve said it would buy $40 billion of Treasury bills a month under a permanent programme of 'Reserve Management Purchases' (RMPs). Bond desks promptly started arguing about what to call it.

How the shrinking stopped

The Fed began running down its balance sheet in June 2022, after the pandemic purchases had pushed it to nearly $9 trillion. It slowed the pace of runoff twice, in the middle of last year and again in the spring, and said in October that the run-off of Treasuries would stop at the start of December. Principal repayments on its mortgage-backed securities are now being reinvested in bills rather than allowed to shrink the portfolio.

The reason was plumbing, not economics. The Fed's overnight reverse repo facility, which once held more than $2 trillion of spare cash from money-market funds, has drained to almost nothing, so further runoff was coming straight out of bank reserves. The Treasury rebuilt its cash account after Congress raised the debt ceiling in July, which drained reserves further. By late October repo rates were trading above the rate the Fed pays on reserves, and banks tapped its standing repo facility in the largest amounts since the facility was created. Those are the signs the Fed watches for when reserves stop being ample.

Officials insist it is not QE

Fed officials put out firm statements that RMPs are not quantitative easing. QE buys long-dated bonds to push down term premia and stimulate demand. RMPs are limited to short-term bills, and the stated aim is only to let bank reserves grow in line with the currency in circulation.

The distinction has substance. When the Fed buys a 10-year bond it removes interest-rate risk from private portfolios, and investors pushed into other long assets bid up their prices; that is how QE eases financial conditions. A three-month bill is almost cash already, and swapping it for a bank reserve changes little about the risk the private sector holds. Bills and reserves also pay similar rates, so the Fed's profit and loss, and the Treasury's financing costs, are barely affected by which one the public holds.

The currency link also explains why the programme is described as permanent. Every dollar of notes the public withdraws from banks is paid for out of reserves, and demand for cash grows over time with nominal incomes. To keep reserves steady as that happens, the Fed must add assets at roughly the same pace, which means its balance sheet will now grow for as long as the economy does. That is a structural commitment rather than a response to a crisis, and it is one reason the programme has no end date.

The 2019 rehearsal

The Fed has been here before. In September 2019 overnight repo rates spiked far above the policy range after a corporate tax date and a large Treasury settlement drained reserves on the same day. The Fed responded in October of that year with purchases of bills at $60 billion a month, and the chairman stressed at the time that the programme was not QE. Markets largely accepted the distinction, until the pandemic swept it aside with purchases of an entirely different scale the following spring.

That episode offers lessons for both sides of the argument. The 2019 bill purchases did calm the funding market without setting off an obvious boom in risk assets, which supports the Fed's case. They also showed how a programme presented as technical can become the permanent floor under a balance sheet that never returns to its old size. Reserves that were meant to be enough in 2019 turned out to be the starting point for the next expansion.

Markets see the same thing

Traders are unconvinced, because the effect looks much the same. The Fed is growing its balance sheet again and financing part of the government's borrowing. Buying $40 billion of bills a month takes up nearly a third of net new issuance at the short end and holds down short-term funding costs.

The Treasury has good reason to welcome that. It has kept the sizes of its longer coupon auctions unchanged for several quarters and leaned on bills to fund the deficit, a choice that only works smoothly if someone absorbs the extra short-dated paper. With the reverse repo cushion gone, money-market funds must buy new bills with cash that would otherwise sit elsewhere; a Fed that takes a third of net bill supply relieves that strain. The effect is to make short-term financing of the deficit cheaper and easier than it would otherwise be.

Who gains from cheap repo

Banks are the most obvious beneficiaries, since a larger stock of reserves eases their liquidity requirements and lowers the rates they pay at month-ends and quarter-ends. Hedge funds running the Treasury basis trade, buying cash bonds and selling futures against them with repo financing, gain from stable funding costs. Money-market funds lose a little, because a large buyer in the bill market holds down the yields they earn. Savers in those funds may notice the difference only at the margin.

The costs are harder to see. A central bank that stands ready to absorb bills whenever funding tightens reduces the pressure on the Treasury to lengthen its debt, and reduces the penalty for leverage built on overnight money. Neither effect shows up in inflation or growth data, but both make the financial system more dependent on the Fed's balance sheet than it was before 2008.

What to watch

The key gauge is the spread between overnight repo rates, measured by the secured overnight financing rate, and the rate the Fed pays on reserves. If that spread stays calm through the year-end and the April tax date, when tax receipts pile up in the Treasury's account and drain reserves, the purchases are doing their job. Heavy use of the standing repo facility despite the purchases would suggest reserves are scarcer than the Fed thinks, and would invite a larger programme.

The label matters less than the balance sheet, which is growing again. The Treasury market now seems to need a standing buyer at the Fed, and that is unlikely to change soon. Expect the purchases to run at or near the announced pace through the April tax season, and expect the Fed's holdings of bills to keep rising for as long as the Treasury leans on short-term debt.