Why is the Fed pumping money into the banking system?
The US central bank has pumped more than $200bn into the financial markets this week. Should we worry? …
Image copyright Getty Images The US central bank has pumped more than $200bn (£160bn) into the financial system this week – the first time there’s been such an intervention since 2008.
The Federal Reserve’s aim was to stabilise what is usually a calm part of the market.
Interest rates in the so-called “repo market” had shot up to 10% in some cases – although the cost of borrowing in that market more typically hovers around the benchmark rate set by the Fed – around 2%.
So what happened and should we worry?
First things first: what’s the repo market?
Banks, hedge funds and other players borrow money regularly on a short-term basis to ensure their books are in order, no matter what their daily activities.
The borrowers typically offer government bonds or other high quality assets as collateral, which they repurchase, plus interest, when they repay the loan – often the next day.
Those repurchase agreements give the repo market its name.
What happened this week?
This is a huge market, with some $3tn changing hands each day, according to the US Office of Financial Research.
Under normal conditions, interest rates in the repo market are low, since the loans are considered safe and there’s plenty of cash on hand.
But this week the cost of borrowing shot up – toward 10% in some cases. And the rate at which banks lend to each other – the Fed’s benchmark – exceeded 2.25%, the top of its desired range.
The rise prompted the Fed to take action. Four times this week, it injected money into the market, offering to buy up to $75bn in treasuries or other assets from banks in a bid to boost bank reserves and keep them lending.
Why did the rates suddenly spike?
Strains in the repo market were among the first signals of trouble ahead of the 2008 financial crisis. Back then banks had suddenly become wary of lending, worried there were unforeseen risks associated with assets that had previously been considered safe.
This time, analysts think what’s happening is caused by an issue with money supply.
Money has been sucked out of the market by two events that happen to have coincided. The first is a tax deadline which means firms need cash to pay what they owe the taxman. The second is the due date for payments on a recent offering of government bonds.
On top of that the Fed has also been steadily reducing the overall supply of money in the market, aiming to get conditions closer to how they were before the financial crisis.
Is that the mystery solved then?
A lot of people still don’t think those explanations are enough to explain the scale of the interest rate rise.
“The thing that’s really confounding is just how much rates moved in a short time,” says Zachary Griffiths, rate strategist at Wells Fargo.
“Everyone’s kind of trying to get a firmer grasp… on all the different nuances that could have led to such a big move.”
There could be other one-off factors triggering this spike, such as an oil bet that went bad after the attack on Saudi Arabia, says Priya Misra, head of global rates strategy at TD Securities.
But she notes that the repo market also showed signs of stress in April and December, suggesting an underling structural issue – namely that the Fed has gone too far in reducing reserves.
“We are in uncharted waters,” she says. “The Fed is trying to figure out the appropriate level of excess reserves.”
Should we be worried?
On Wednesday, Federal Reserve Chair Jerome Powell conceded that the Fed had not anticipated such a large spike in interest rates, despite warnings of a possible crunch.
Mr Powell was also quick to talk down concerns that the issue signals a bigger problem or that the bank had lost its grip on its policy.
“We don’t see this as having any implications for the broader economy, or for the economic outlook, nor for our ability to control rates,” he said.
And the Fed used to conduct these kinds of market operations prior to the financial crisis, without prompting undue concern.
Did the Fed’s intervention work?
Rates dropped back following the Fed’s action, and so far stock markets and other parts of the system don’t appear to have been affected.
But analysts warn that the turmoil is likely continue, saying the end-of-quarter rush to square up company balance sheets could cause more stress.
“Our big takeaway there is, we’re going to have to keep an eye on this,” says Mr Griffiths.
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