Back to Blog

Unintended Consequences

Feb 01, 2021

Executive Summary

  • Short-term interest rates are coming under pressure in a fashion that will require the Federal Reserve to defend the zero-lower-bound.
  • Rapid growth in total banking reserves will cause banks to lower the rate on some deposits to limit their balance sheet growth, which comes at a cost.
  • The demand for Treasury bills from money market funds and the Federal Reserve will outweigh the limited supply of new bills in 1H 2021 due to an overfunded TGA.
  • The Federal Reserve will be forced to take action to lift short-term money market rates.
  • The Federal Reserve may be able to solve this problem through a series of "tweaks," but if short-term interest rates fall too far, it may start to drag the belly of the Treasury curve down to the zero-lower-bound.

Unintended Consequences

(To expand images, you can "right-click" and select "open image in new tab.")

The crisis in March of 2020 caused the Federal Reserve and the Treasury to ease policy in an unprecedented fashion. The lack of immediate inflationary pressure or disruption to currency funding markets fueled a narrative that the Federal Reserve could grow its balance sheet to double or triple or even more than its current size of slightly more than $7 trillion. 

 Unintended consequences always emerge from theories of grand design. In this note, we will explore how and why short-term interest rates have come under pressure, what the Federal Reserve can do to prevent short-term interest rates from falling below 0%, and why this may be important to the broader Treasury and currency market. 

Several Federal Reserve documents will be sourced throughout and linked here for further reading. Modern Money Mechanics is a workbook published by the Federal Reserve Bank of Chicago, detailing money creation in a fractional reserve system. How The Fed Changes The Size Of Its Balance Sheet is a helpful document to understand the changes in the balance sheet of the Federal Reserve, the private banking system, the non-bank public, and the Treasury balance sheet. A Return To Operating With Abundant Reserves is the most recent document discussing the issues that may emerge across short-term interest rates from a rapid rise in bank reserves and the possibility of limited or no new Treasury bill issuance. 

Chris Whalen also penned an article in recent days addressing the issue of the Treasury General Account "TGA" and the possibility of negative short-term rates. 

To summarize, when reserves in the banking system grow far beyond what banks need for payment purposes, banks look to exchange reserves with another bank that may need more reserves and look to deploy new cash into securities or loans. Under new regulations since the 2008 financial crisis, banks can be penalized for growing their balance sheet, particularly when investing in risky securities or loans. As a result, Treasury bills, the most sought after and purest form of collateral in the global financial system are suitable replacements for reserves, particularly when the interest rates on Treasury bills exceed the interest rate paid on reserves. 

We have already seen Treasury bills out to 12-months trade below the 0.10% earned on reserves at the Fed. There are currently about $5 trillion of Treasury bills outstanding. There are price indiscriminate buyers of Treasury bills between what the Federal Reserve owns and the $4 trillion across money market funds. 

The Treasury department, expecting more stimulus, already raised a substantial amount of money that is sitting in the Treasury's checking account at the Federal Reserve, also known as the "TGA." If Congress agrees to a stimulus package that is less than the roughly $2 trillion already funded in the TGA, the Treasury may be in a position, based on debt ceiling rules, to "return" the money in the Treasury account back to the public in the form of canceled T-bill or T-note issuance. 

 The combination of trillion of dollars of money market funds, bank reserves that are expected to exceed $5 trillion, and the possibility of canceled T-bill auctions may force short-term interest rates deeply negative, forcing the Federal Reserve to defend the zero-lower-bound "ZLB." 

In the section below, we'll explore what is causing the pressure on short-term rates, why it is expected to get worse, what the Fed can do about it, and why it might matter to the broader Treasury and currency market.

Excessive Growth In Bank Reserves

After the 2008 crisis, the Federal Reserve switched to operating in an "ample reserves" regime, also known as a "floor" system. In a floor system, the Federal Reserve supplies more than enough (ample) reserves into the system to ensure strong control of short-term interest rates with the primary influence being interest paid on excess reserves "IOER" or in today's zero reserve requirement, just interest on reserves "IOR."

Prior to the 2008 crisis, the Fed operated in a regime in which "just enough reserves were supplied to meet banks’ reserve requirements and payment needs."

The ample reserve or floor system is helpful when a significant amount of liquidity is injected into the system because the control over the size of the balance sheet and interest on reserves can be used as two separate tools. 

In an ample reserves framework, reserves are instead supplied in an amount that leaves most banks with reserve balances above what they need for payments purposes. As a result, many are comfortable investing excess balances when the return on other high-quality liquid assets is above the interest paid on excess reserves (IOER), and also taking deposits at rates near IOER.11

In other words, the Federal Reserve can add "too many" reserves into the system, far above what banks need for payment purposes. As a result, banks look to trade away their reserves for other high-quality assets, like T-bills, when T-bill rates are higher than IOR.

Treasury Bills & IOR:

Source: FRED

Currently, T-bills are already trading below IOR. Thus, banks can either park the reserves at the Fed for 0.10%, which places a major drag on total net interest margins, or banks can lower the rate they pay on certain deposits to continue earning a spread over the short-term rates. In today's world of banking regulations, increasing the size of the bank balance sheet comes with a regulatory cost, so lowering the rate on certain deposits can ensure adequate net interest margins. 

National Savings Deposit Rate:

Source: FRED

The last time reserves in the banking system were this elevated, around $3 trillion in 2014, the Fed Funds Rate and Treasury bills traded almost 0.20% below IOER. 

IOER was 0.25% in 2014 compared to 0.10% today, which is another reason why the zero-lower-bound was not breached by most short-term market rates despite trading nearly 0.20% below IOER. 

2014: T-Bills and IOER:

Source: FRED

Why did about $3 trillion in reserves place massive downward pressure on short-term rates in 2014 but not in 2020 with even more reserves? 

Lorie Logan identified two differences. The first difference is simply reserve management in the banking system. Due to new regulations, banks are generally more comfortable holding higher balances of reserves and thus putting slightly less pressure on reserve alternatives across short-term rates. 

The second major difference is the quantity of T-bill issuance in 2020 compared to other years. 

To fund the multi-trillion dollar CARES Act and raise additional money for precautionary purposes, the Treasury Department issued nearly $3 trillion of T-bills this year, highlighted by the chart from Logan's speech

T-Bill Issuance:

Source: Federal Reserve

The supply of T-bills was so high this year that money market funds, the Federal Reserve, and other market participants in short-term rates had an abundance of supply. 

Indeed, analysis by New York Fed colleagues finds that, controlling for changes in reserves, an increase of $1 trillion in the supply of short-term Treasury securities raises the spread of the effective federal funds rate relative to IOER by about three basis points.18 This helps explain some of the firmness in money market rates in recent months.

Nearly $3 trillion in T-bill supply this year could have placed roughly 0.09% of upward pressure on short-term rates. Already trading below IOR at 0.10%, normalized T-bill supply alone may be enough to push short-term rates into negative territory, something the Federal Reserve will have to address at the risk of being sucked into negative interest rate policy. 

T-bill supply is not only expected to normalize in 2021 but may actually shrink (no T-bill actions) due to an overfunded TGA. 

Over Funded Treasury General Account

The Treasury General Account or "TGA" is the checking account of the Treasury Department that is held at the Federal Reserve. The TGA is a liability on the Federal Reserve's balance sheet, similar to bank reserves, so when the TGA goes down, bank reserves go up and vice versa. 

 The Treasury Department issued trillions of dollars in new debt to fund the CARES Act in March and additional funds for an expected second-round stimulus effort. 

Currently, the TGA sits at roughly $1.6 trillion, but the new stimulus currently under negotiations looks to come with a price tag of less than $1 trillion. 

Treasury General Account:

Source: FRED

As a result, the TGA account is "over-funded." The Treasury cannot raise money from the public and have the funds sit idle in the TGA, the funds have to be used in a reasonable amount of time, so extra funding in the TGA will have to be "returned" to the public in the form of less Treasury issuance next year. Typically, the most commonly issued T-bills are reduced in supply, but as we noted above, there is already downward pressure and a Treasury bill shortage. 

We know that more than $3 trillion in bank reserves is more than "ample" and caused downward pressure on short-term rates in 2014 and today. The impact has been negated slightly this year due to different reserve management practices and the massive supply of bills adding about 0.09% of upward pressure on short-term rates. 

Remember that when the TGA goes down, bank reserves go up. So either way, either through fiscal spending or "returning the funds," bank reserves are expected to surge from $3.2 trillion to more than $5 trillion by the summer of 2021, without any additional easing from the Federal Reserve. 

Currently, as of November, there are about $5 trillion in total T-bills. 

T-Bills Outstanding:

Source: Treasury Department

The Federal Reserve owns about $1 trillion in bills, so the outstanding supply drops to about $4 trillion. 

Interestingly, the last time there was downward pressure on short-term rates in 2014 with more than ample reserves, the Federal Reserve owned virtually no bills. Today, the Fed owns more than a trillion dollars of bills at a time when there is expected to be a major shortage of bills in the coming months. 

Federal Reserve Ownership of Bills:

Source: FRED

Treasury bills are the most sought after form of safe collateral in the global financial system with many uses. 

Of the $4 trillion in bills available to the public, there are $4 trillion sitting in retail and institutional money market funds alone that are more price-insensitive buyers of short-term paper. 

Money Market Funds:

Source: FRED

By the summer of 2021, reserves in the banking system might exceed $5 trillion, and the issuance of new Treasury bills may dry up to offset the overfunding in the TGA. 

Chris Whalen commented with help from George Goncalves: 

As we’ve noted several times since the start of quantitative easing, allowing the FOMC to conduct massive open market purchases of Treasury securities and MBS has a considerable downside – especially when the Fed is also holding the Treasury’s cash in the TGA. The Fed and Treasury are alter egos, like two faces of a Hindu deity, thus the market risk is magnified when the Treasury and the Fed are pursuing divergent policy goals.

The other more profound point raised by the size of the TGA is that the Treasury now accounts for about 25% of the Fed's balance sheet. Or put another way, the Treasury is funding about $1.6 trillion worth of QE. The cash deposits made by Treasury into the TGA must be collateralized with Treasury securities, meaning that $1.6 trillion worth of QE has no impact on bank reserves and is not supporting FOMC policy. As a practical as well as political matter, Treasury must reduce the size of the TGA or risk detracting from the FOMC's monetary policy actions.


Overall, the Fed and Treasury both over-reacted to Covid induced market vol earlier in the year and now will need to deal with the hangover into 2021.

In 2014, massive downward pressure was placed on short-term rates from a high level of bank reserves. While today's reserve management practices favor more reserves, by the summer of 2021, a situation could unfold in which little or no T-bill supply hits the market at a time when reserves are $5.5 trillion instead of $3 trillion, the Fed owns $1 trillion of bills compared to almost none and money market funds are $2 trillion larger than 2014. This cocktail could exert downward pressure on short-term rates, pushing some market rates deeply negative. 

Negative interest rates across dollar funding markets could raise many potential problems and, optically, is not something the Federal Reserve is likely to let stand. 

The Federal Reserve has virtually no control over long-term rates but has explicit control over short-term rates. The Federal Reserve will have to respond if they look to maintain control over the short-term interest rate policy. 

Ironically, at a time when yield curve control is gaining ubiquitous coverage, the Fed may be forced to use some form of yield curve control to keep rates up, not down. 

The Options For The Federal Reserve

The Federal Reserve has several options and tools to use in an effort to prevent short-term rates from falling too far. 

First, the Fed can raise interest on reserves from 0.10% to 0.15% or something slightly higher. IOER has a strong influence on short-term rates, and higher interest on reserves may incentivize less demand for bills. 

The Fed made the exact opposite move in 2018 when reserves were too scarce as opposed to beyond ample. The Fed lowered the interest on excess reserves several times to prevent the Fed Funds rate and other short-term rates from shooting too high. A lack of reserves can put upward pressure on short-term rates, while an overabundance can put downward pressure on rates. 

Secondly, the Federal Reserve can engage in some "twist" operation in which they continue to grow their balance sheet on net but "sell" their T-bill portfolio while buying long-term bonds. In other words, the Fed can extend the weighted average maturity "WAM" of their bond purchases to remove demand from the short-end of the Treasury curve. 

Thirdly, the Fed can offer overnight reserve repo operations "ON RPR" to help control short-term rates. 

The Desk has conducted overnight reverse repo operations daily since 2013. The ON RRP is used as a means to help keep the effective federal funds rate from falling below the target range set by the FOMC. The overnight reverse repo program (ON RRP) is used to supplement the Federal Reserve's primary monetary policy tool, interest on excess reserves (IOER) for depository institutions, to help control short-term interest rates. ON RRP operations support interest rate control by setting a floor on wholesale short-term interest rates, beneath which financial institutions with access to these facilities should be unwilling to lend funds. ON RRP operations are conducted at a pre-announced offering rate, against Treasury securities collateral, and are open to a wide range of financial firms, including some that are not eligible to earn interest on balances at the Federal Reserve.

Fourth, the Federal Reserve and bank regulatory committees can relax leverage ratios and other regulations that make it costly for banks to grow their balance sheet. For example, Treasury securities were temporarily excluded from the Supplemental Leverage Ratio "SLR." Making this relaxation permanent may make banks more willing to grow their balance sheet rather than taking the rate down on some deposits. 

The Federal Reserve is likely to use some or all of these tools to help alleviate some of the pressure on short-term rates while the TGA and bank reserves "swap" balances. 

These pressures may ease in the second half of 2021 as T-bill issuance normalizes again or the Federal Reserve correctly addresses the problem.

At the very least, we now understand that extreme monetary easing may have negative consequences. 

Why This Matters

Why does this matter? This matters for two key reasons.

First is that we now understand monetary policy has limitations. If the Fed wants to grow its balance sheet with trillions more in quantitative easing, they may have to take additional action to defend the zero-bound or do what other developed central banks did, and succumb to the downward pressure of market rates and accept a negative interest rate policy. 

Secondly, if the Fed does not execute a defense plan with precision and success, short-term interest rates could fall deeply negative, as low or lower than -15bps to -20bps. Short-term rates that fall into negative territory would force money market funds to extend their maturity profile to protect their net asset value, driving interest rates down through the belly of the curve, something we have started to see very slightly in rates out to 2-years. 

Moreover, negative interest rates across US short-term rates will make it very cheap if not free to hedge US dollar exposure, creating a larger spread between US rates and other global rates on a currency-hedged basis. 

US 10-Year Rate (FX-Hedged) vs. German 10-Year:

Source: Bloomberg

The cyclical upturn in the global manufacturing sector, should it continue through 2021, will help the Federal Reserve with this unintended consequence. 

The cyclical momentum should continue to place upward pressure on long-term interest rates, allowing the Federal Reserve to engage in a "twist" operation without flattening the Treasury curve in a major way. 

If, however, the Fed does not act appropriately or the cyclical upturn loses momentum, and the Fed is forced to deal with this problem during a time when market rates have downward cyclical pressure, choices will be limited as a twist operation would exacerbate the flattening pressure across the Treasury curve. 

Over the coming weeks and months, we can monitor the spread between the Effective Fed Funds Rate "EFFR" and interest on excess reserves "IOER." 

We can also monitor the interest rates on short-term Treasury bills, which continue to decline. 


Join The Free EPB Macro Research Blog

New research, content, and special offers delivered straight to your inbox. 

We hate SPAM. We will never sell your information, for any reason.