On September 17, the overnight Treasury repurchase agreement (repo) rate spiked to 6%—up from just 2.2% a week earlier and the highest level in more than 15 years (see DTCC GCF repo index). Oddly, this turmoil occurred at a time when the Fed had begun lowering its policy rate for the first time in more than a decade and market participants anticipated further policy easing ahead.

What led to this sudden disruption in short-term funding markets that been relatively calm in recent years? Had the Fed lost control? In our view, the explanation for the sudden rise in overnight interest rates is straightforward: the shrinkage of the Federal Reserve’s balance sheet that began in October 2017 reduced the aggregate supply of reserves gradually to where banks’ demand for reserves was insensitive to interest rates. Consequently, large temporary fluctuations in the supply of reserves that would have had virtually no impact even a few months ago, triggered sizable upward interest rate fluctuations.

Consistent with this view, the Federal Reserve recently took action to prevent a recurrence of the September disorder. At an unscheduled video conference meeting on October 11, the FOMC agreed to additional regular purchases of Treasury bills at least into the second quarter of 2020. The goal of this balance sheet expansion is to maintain reserve balances at least as high as their level in early-September before the turmoil began.

In the remainder of this post, we discuss the evolution of the supply and demand for reserves in recent years. We argue that, because no one—including the Fed—knew the precise level of reserves at which the demand curve would become inelastic, an episode like the one on September 17 was virtually inescapable as reserve supply declined. If our diagnosis of the cause is correct, then recent actions should help put the issue to rest. Yet, given the inevitability of the event―that the day would come when shrinking reserve supply hit the inelastic part of the reserve demand curve―the Fed could (and should) have been prepared. If so, it could have avoided even a temporary dent in its well-deserved reputation for operational prowess….