The Federal Reserve's overnight reverse repurchase tool is nearly exhausted, which may put pressure on its ability to control short-term interest rates

According to the Zhitong Finance APP, as part of open market operations, the Federal Reserve maintains the overnight reverse repurchase agreement (RRP), which is a place for non-bank entities to deposit cash in exchange for the interest rate set by the Federal Reserve. This mechanism allows the Federal Reserve to set a lower bound on short-term borrowing rates, which are determined by monetary policy.

Due to the "helicopter money" policy adopted by the U.S. government during the pandemic, an excess of funds in the system led to a massive influx of money into the RRP. At that time, the collision of three factors—money market funds, government agencies (such as the strong demand for agency-backed mortgages), and a shortage of Treasury bills—made the RRP the primary destination for funds.

In itself, the RRP has indeed fulfilled its intended function—absorbing liquidity. By the end of 2022, the scale of RRP usage reached a peak of $2.5 trillion. However, it is worth noting that the current scale of RRP usage has fallen by over 95% from its peak, down to a recent low of $22 billion.

Of course, this does not mean that the Federal Reserve does not hold a large amount of assets. It still holds them, just not in the RRP. Currently, the Federal Reserve still holds $3.3 trillion in reserves, down from a peak of $4.2 trillion in 2022.

For a long time, the usage rate of the Federal Reserve's RRP has been seen as a measure of excess liquidity in the financing market. Now that its usage scale continues to decline, the reason is that the U.S. Treasury is issuing more short-term bonds to fill the expanding deficit, attracting funds away from this key liquidity buffer.

The sluggish RRP usage scale means that short-term rates will be more market-driven. Although it is almost impossible to deviate from the federal funds rate, this does mean that during tax payment periods and quarter-ends, interest rate fluctuations may be larger, as institutions like money market funds will rely more on the open market to adjust liquidity rather than relying on the RRP.

Once the RRP is exhausted, Treasury bond issuance and the Federal Reserve's balance sheet reduction will directly consume bank reserves. These reserves are crucial for providing the buffer needed to ensure the smooth operation of the market and will also determine the pace of the Federal Reserve's balance sheet reduction.

What is concerning is that when the next round of quantitative tightening (QT) needs to be initiated, reserves may still be at low levels, and without a robust RRP, the so-called "runway" will be shorter. If the next round of QT does not include interest rate hikes, then the RRP is not expected to accumulate funds again, increasing the risk of reserve shortages It is worth mentioning that the Federal Reserve maintains short-term interest rates within the target range through so-called "micro quantitative easing (QE) and QT," which involves quickly injecting or absorbing liquidity in small amounts in the Treasury market. The Fed's ability to control the short end of the yield curve through the reserve interest rate should not be underestimated, but this ability may be nearing its end, which would give mechanisms like RRP greater significance.

Reportedly, the "Fiscal Reserve Interest Accountability Act" has recently been submitted to Congress. If passed, this bill would eliminate the Fed's ability to pay interest on deposits. This could lead to an outflow of the $3.3 trillion in reserves held by the Fed, shifting the market focus to the repurchase mechanisms (including reverse repos) and the Fed's ability to conduct QE and QT through its balance sheet. Because the Fed would no longer be able to use the tool of paying interest to participate in the deposit market alongside the federal funds rate, it would hinder its ability to help set short-term rates.

It remains unclear whether the Fed can still rely on "micro QE and QT" to adjust short-term rates without these reserves, as it did before 2008. However, it should be noted that the large-scale QE introduced in 2008 is fundamentally different from the current system, which suggests that the Fed may not need to continue relying on its ability to pay interest to control short-term rates. So far, the Fed's reserve abundance has performed well, remaining robust even under the shock of 2020, but all of this has occurred during a period when it could pay interest on reserves.

Overall, the Fed's reverse repo tool has now finally been drained. As it re-enters a loosening cycle and the market anticipates future rate cuts, the focus has shifted to the Fed's balance sheet and the liquidity that excess reserves can provide.

However, the new legislation threatens the Fed's ability to pay interest on reserves, which could lead to the $3.3 trillion in reserves flowing back into the private market. This means more liquidity will circulate in the hands of the private sector rather than being dormant in one of the Fed's tools, which is a significant boon for risk assets but may also reduce the Fed's ability to set short-term rates, potentially causing more rate fluctuations during tax payment periods and at the end of quarters