The Fed’s reverse repo facility reached $2.554 trillion, according to Reuters

Michael S. By Derby

NEW YORK (Reuters) – A key facility used by the Federal Reserve to control short-term interest rates saw record inflows on Friday, the final trading day of the year.

The New York Fed said its reverse repo facility drew $2.554 trillion from money market funds and other qualified financial institutions, better than the previous high-water mark seen on Sept. 30 when total inflows were $2.426 trillion.

Cash surges are likely to pick up further at the end of the year, in a typical quarter-end pattern. On those dates, for various reasons, many financial institutions preferred to park their money in the central bank rather than in the private markets.

The central bank’s reverse repo facility has been very active for some time. After seeing almost no hikes for a long time, money began to gravitate toward the Fed in the spring of 2021 and has continued to grow since then. Daily reverse repo usage has topped $2 trillion since June.

A reverse repo facility is a de facto loan from the central bank to eligible financial institutions in cash. The current rate stands at 4.3%, which is often the best return on private sector short-term loan rates.

The reverse repo facility is designed to provide a soft floor for short-term rates and the federal funds target rate, which achieves the central bank’s main tool of employment and inflation mandates. To set the upper end of the range, the central bank pays deposits to banks to park money in the central bank, and the interest rate on reserve balances is now 4.4%.

The federal funds rate is currently set between 4.25% and 4.5% and was trading at 4.33% as of Friday, tied between the reverse repo and interest on reserve balance rates.

No signs of shrinkage

Despite the massive use of reverse repositories, central bank officials are unconcerned about continued large inflows, and some in financial markets worry about the prospect of the Fed taking the life out of borrowing and lending in the private money market.

Central bank officials expect the use of the reverse repo facility to decline as the central bank raises its interest rates in an effort to curb hyperinflation. But that hasn’t happened yet, and some in the markets now believe continued high use of the Fed facility will be in place for some time to come.

Research by the New York Fed has suggested that bank regulatory issues are keeping demand high for the Fed’s reverse repo instrument. Meanwhile, the Kansas City Fed added that large inflows are tied to limited private market investment opportunities and policy uncertainty.

Strong cash inflows to the central bank may not have alarmed central bankers, but it has put their operations at a practical disadvantage. A central bank is financed by interest on securities it owns and services it provides to the financial community. Usually it makes a significant profit and returns to the exchequer as per law.

Now, the cost of paying interest on reverse repos and reserve balances is higher than the income. The Fed said on Thursday that as of Dec. 28, the accounting measure it uses to track losses was $18 billion. Many observers expect the Fed to raise rates further and maintain them at high levels would result in substantial losses for the Fed over time, even if those losses do not affect the Fed’s monetary policy work.