By Michael S. Derby
(Reuters) -U.S. Treasury Secretary Scott Bessent said on Tuesday the Federal Reserve’s system of managing interest rates is struggling and needs to be simplified.
“We’ve gotten to this point where monetary policy has gotten very complicated” and the U.S. central bank should “simplify things,” Bessent said in an interview with CNBC.
“The Fed has taken us into a new regime, and what is called ample-reserves regime. And it looks like that might be fraying a bit here in terms of whether the reserves are actually ample,” Bessent said.
The Treasury secretary did not say what he meant by fraying.
The Fed has faced and continues to face challenging money market conditions tied to how it has been managing its $6.56 trillion balance sheet and financial system liquidity levels.
Officials at the Fed’s last policy meeting announced that they would stop the contraction of the central bank’s overall balance sheet at the start of December. They did so as liquidity in financial markets in the run-up to the late October policy meeting tightened enough to complicate control of the federal funds rate, the Fed’s primary tool to achieve its inflation and employment goals.
The turbulence was such that it drove eligible financial firms to borrow notable levels of cash from the Fed via its Standing Repo Facility, a tool used to put a ceiling over short-term interest rates. There were also intermittent large inflows of cash into the Fed’s reverse repo tool, which is used to set a floor underneath money market rates.
CRITIC OF FED BALANCE SHEET
Bessent has been a persistent Fed critic who has expressed particular concern about its large balance sheet, which is primarily stocked with trillions in bonds bought in large part to stabilize financial markets and to provide stimulus to the economy.
The large footprint, at least in dollar terms, is seen by Bessent and others, including some at the Fed, as distorting market pricing levels. There also has been concern about the complex way the Fed manages rates, which relies on liquidity facilities and eschews the highly managed system it used prior to the financial crisis that began nearly 20 years ago.
“A large balance sheet increases the Fed’s footprint in financial markets, distorts the price of duration and the slope of the yield curve, and potentially blurs the line between monetary and fiscal policy,” Kansas City Fed President Jeffrey Schmid said in a speech on November 14.
Others have lamented that managing liquidity under the current system has led the Fed to pay out substantial sums to financial institutions. That approach turned the Fed from an institution that made substantial profits to one that is currently $240 billion in the red, even as those losses have no impact on its ability to operate.
Despite the complicated nature of the current system, it has widespread support from policymakers, not least because much of it operates on autopilot and does not require the constant interventions the pre-financial crisis system required.
At the same time, Fed officials have warned any push to end the current system would be wrenching, as it would require the aggressive sell-off of Fed-owned Treasury and mortgage-backed bonds, which would cause very large increases in real-world borrowing costs.
VOLATILITY ANTICIPATED AS YEAR ENDS
The Fed is likely to face tough sledding on money markets as it moves to the end of the year, an always volatile period for money market liquidity levels.
Bill Nelson, the chief economist at the Bank Policy Institute, notes that large Treasury settlements on Friday and Monday will cause strains on money market liquidity. He said in a note that the Fed should announce market liquidity interventions to ensure the system has enough cash to limit rate volatility.
The end of December could also be turbulent, as it’s also the close of a quarter and calendar year. The final trading day of the year usually sees large-scale use of Fed liquidity as some lenders pull back while others scramble for cash.
Managing liquidity could be particularly challenging because the SRF, which is finally seeing regular use, has not been tapped as strongly as many had expected, even when borrowing from it offers a lower rate than what’s available in private markets. Some observers reckon financial firms are avoiding the tool lest it send signals that they’re in trouble.
On November 12, Roberto Perli, a New York Fed official who leads the implementation of monetary policy, told a conference that from the central bank’s point of view, “It is desirable and fully expected that the (SRF) be used whenever it is economically sensible to do so.”
Recently released Fed meeting minutes said officials are exploring ways to make the tool more attractive, including moving it to a central clearing mechanism, which could make the facility easier to use.
Beyond those near-term issues, Fed officials have said that to manage liquidity they soon will have to increase the size of their holdings again to maintain the right level of financial market liquidity. That move could be incorrectly viewed as stimulus buying, and it could once again put the central bank at odds with Bessent’s desire for smaller central bank holdings.
(Reporting by Michael S. Derby; Editing by Paul Simao)
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