New York Fed's new indicator reveals ample market liquidity, Morgan Stanley rebuts: the new indicator is not perfect!

According to the Zhitong Finance and Economics APP, JPMorgan Chase stated that the small size of the federal funds market makes its key interest rate an imperfect gauge for measuring the liquidity of the U.S. financial system.

Just last week, the New York Fed introduced a tool called Reserves Demand Elasticity (RDE), which indicates that the balance between reserve supply and demand in the banking system is in equilibrium. This suggests that the Fed can continue to withdraw liquidity from the system through its quantitative tightening plan. The tool is calculated using data on federal funds transactions and reserve amounts.

JPMorgan Chase strategists Teresa Ho and Pankaj Vohra wrote in a report released last Friday, "Stepping back, we are somewhat surprised by the apparent emphasis the Fed seems to place on the federal funds rate as a measure of market liquidity. While the federal funds rate reflects the price at which banks trade their 'excess' reserve balances, the federal funds market is quite small."

Currently, market participants have been closely monitoring liquidity indicators and the funding market to look for clues on when the Fed's quantitative tightening (QT) will stop, and whether this policy will end before liquidity pressures become worrisome. Dallas Fed President Robert Kaplan stated on Monday that market liquidity remains "very ample."

Roberto Perli, manager of the Federal Reserve Bank of New York's System Open Market Account (SOMA), listed a series of indicators that officials are watching to determine when bank reserves start to become scarce - the point at which the Fed's QT may have to stop.

JPMorgan Chase suggests that the Fed may complete QT by the end of 2024, "as any further loss of liquidity will have an increasingly large impact on reserves."

In the view of the bank's strategists, the limited number of participants and the small size of the federal funds market have made this rate a surprising focus for the Fed. The daily trading volume in the federal funds market is typically between $500 billion and $1 trillion. In contrast, the overnight loan market collateralized by U.S. Treasuries (used by the New York Fed to calculate the Secured Overnight Financing Rate (SOFR)) exceeds $2 trillion daily.

Furthermore, according to JPMorgan Chase, the Federal Home Loan Banks (FHLBs) account for most of the reserve lending in the federal funds market, while SOFR transactions involve "a broader set of market participants," including banks and non-bank institutions.

They wrote, "In other words, SOFR provides a more comprehensive market liquidity gauge as it reflects the liquidity needs of a range of market participants."

While the surge in SOFR in late September is not necessarily a sign of reserves becoming scarce, the bank's strategists indicate that it suggests "the challenge of reallocating reserves in the financial system to those who need liquidity is becoming increasingly difficult."