The Federal Reserve's overnight reverse repurchase tool is near exhaustion, and its ability to control short-term interest rates may be under pressure.

As part of open market operations, the Federal Reserve maintains the overnight reverse repurchase agreement (RRP) tool, where non-bank entities deposit cash in exchange for the interest rate set by the Federal Reserve. This mechanism allows the Federal Reserve to set a floor for short-term borrowing rates, which is determined by monetary policy. During the pandemic, the excess funds within the system led to a significant influx of funds into RRP due to a combination of factors such as high demand from money market funds, government agencies (such as agency-backed mortgage demand), and a shortage of Treasury securities, making RRP the main destination for funds. RRP has indeed fulfilled its intended function of absorbing liquidity. By the end of 2022, the peak usage of RRP reached $2.5 trillion. However, it is worth noting that the current usage of RRP has fallen by over 95% from its peak to a recent low of $220 billion. Of course, this does not mean that the Federal Reserve does not hold a significant amount of assets. It still does, just not through RRP. Currently, the Federal Reserve still holds $3.3 trillion in reserves, lower than the peak of $4.2 trillion in 2022. Historically, the utilization of the Federal Reserve's RRP has been seen as a gauge of excess liquidity in the financing market. Its continued decrease in usage is due to the issuance of more short-term bonds by the US Treasury to fill in the expanding deficits, attracting funds to flow out from this key funding source. The declining usage of RRP implies that short-term rates will be more market-driven. Although it is almost impossible for them to deviate from the federal funds rate, it does mean that there may be greater fluctuations in interest rates during tax payment periods and quarter-ends as institutions like money market funds rely more on open markets to adjust liquidity, rather than on RRP. After the exhaustion of RRP, the issuance of Treasury debt and the Federal Reserve balance sheet reduction will directly deplete bank reserves. These reserves are crucial in providing the necessary funding to buffer the market and ensure its smooth operation, and will also determine the pace of the Federal Reserve's balance sheet reduction. Concern arises when the next round of quantitative tightening (QT) needs to be initiated, as reserves may still be low. Without a robust RRP, the runway would be shorter. If the next round of QT does not involve raising interest rates, RRP is not expected to accumulate funds again, increasing the risk of reserve shortages. It is worth mentioning that the Federal Reserve's ability to control short-term rates by adjusting the rate on reserves is crucial. However, this ability may be reaching its limits, giving mechanisms like RRP greater significance. Recently, the "Financial Reserves Interest Accountability Act" has been submitted to Congress. If passed, the Act would eliminate the Federal Reserve's ability to pay interest on reserves. This may lead to the outflow of the $3.3 trillion in reserves held by the Federal Reserve, shifting the market's focus to repurchase mechanisms (including both reverse and forward) and the ability of the Federal Reserve to conduct QE and QT through its balance sheet. The Federal Reserve would not be able to participate in the deposit market along with the federal funds rate, which helps set short-term rates. It is currently unknown whether the Federal Reserve, without these reserves, would still be able to adjust short-term rates like it did before 2008 through "mini QE and QT." It should be noted that the large-scale QE introduced in 2008 was different from the current system, meaning that the Federal Reserve may not necessarily need the ability to pay interest on reserves to control short-term rates. So far, the Federal Reserve's reserve adequacy has been good, remaining resilient even during the shocks of 2020, but all this occurred during a period when it could pay interest on reserves. In conclusion, the Federal Reserve's reverse repurchase agreement tool is now finally depleted. In the context of re-entering an easing cycle and market expectations of future rate cuts, attention has shifted to the Federal Reserve's balance sheet and the liquidity provided by excess reserves. However, the new legislation poses a threat to the Federal Reserve's ability to pay interest on reserves, which may lead to the outflow of the $3.3 trillion in reserves held by the Federal Reserve back into the private market. This means that more liquidity will circulate in private hands rather than lying dormant in a tool of the Federal Reserve, which is a significant advantage for risk assets but may also lead to a weakening of the Federal Reserve's ability to set short-term rates, potentially causing more interest rate fluctuations during tax payment periods and quarter-ends.