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The New York Federal Reserve recently introduced a new metric to gauge the liquidity of the US financial system. Surprisingly, it indicated that bank reserves are still “abundant”. This revelation has sparked interest in understanding the transition from an era of abundant reserves to one of ample or just comfortable levels.
Typically, we only realize we are in an uncomfortable situation when things start to malfunction. The surge in the secured overnight financing rate (SOFR) at the end of the quarter raised concerns about a potential shift in the liquidity environment.
The NY Fed’s new tool focuses on the Fed funds market and its response to changes in reserves, utilizing non-public daily data on bank balances. The metric aims to hover around zero in the presence of abundant reserves.
The September 2019 repo market turmoil serves as a prime example of when things became strained.
While this new measure is innovative, its outcome was not surprising. It is unlikely that the Fed would publicize it if it indicated alarmingly tight reserves. The fact that the NY Fed President’s name is associated with the tool reflects high-level involvement.
However, like any attempt to simplify complex dynamics into a single measure, there may be underlying uncertainties. Teresa Ho from JPMorgan highlighted the dynamic nature of reserve scarcity and the challenge in defining a precise threshold.
The reliance on the Fed funds market may also raise questions given its reduced activity compared to the more diverse SOFR market. JPMorgan emphasizes the importance of considering both bank and non-bank liquidity in assessing overall market liquidity.
Despite potential uncertainties, the publication of such tools by the Fed indicates a proactive approach to monitoring the financial system. This vigilance helps minimize the risk of unexpected disruptions.
Furthermore, there appears to be ample liquidity in the system, and the Fed has adjusted its balance sheet reduction pace to prevent any mishaps.
In the event of errors, the central bank is equipped with tools to manage any turbulence. While the 2019 incidents were concerning, they did not result in significant harm beyond reputational damage.
In summary, while there are potential risks, the situation is not systemic. However, it would certainly be intriguing if the NY Fed’s assessment turned out to be incorrect.