Fed Adjusts Reverse Repo Rate: A Step Towards Liquidity Control

The US Federal Reserve has made a significant adjustment to its interest rate policy tool by lowering the rate for its reverse repurchase agreement more sharply than the benchmark interest rate. The new reverse repo rate is now 4.25%, while the target range for the benchmark rate has been reduced by 0.25 percentage points to 4.25% to 4.5%. Economists interpret this expected decision by the Fed as an attempt to withdraw excess liquidity from the financial system. The Fed pays interest on its overnight repo transactions, offering money market funds and others the opportunity to park excess funds safely and securely with the central bank. This rate serves as a soft floor for all short-term interest rates. With the adjustment, the rate for bank-issued interest now moves to 4.4% from the previous 4.65%. This fine-tuning by the Fed is intended to ensure control over the benchmark rate corridor and could make the reverse repo business less attractive, which might encourage participants to look for more profitable investment opportunities. Since spring 2022, the reverse repo business has increased from insignificant use to a peak of $2.6 trillion at the end of 2022 but has gradually declined due to the reduction of the Fed's balance sheet. The decrease in reverse repo holdings could mean that simultaneous efforts to shrink Fed investments could impact banks' reserves, which could signify the final stage of withdrawing pandemic market support. While financial markets expect a stopping point in May, uncertainty remains regarding the endgame for the reduction of the Fed's balance sheet. The combination of fund outflows from this instrument with expected market volatility at year-end and government financing issues next year could influence this process.