Liquidity concerns creep into Fed minutes as repo usage surges

Liquidity concerns creep into the Fed's minutes as repo usage soars.

Minutes of the Federal Reserve's December policy meeting revealed concerns about a potential liquidity shortage in the financial system even as interest rates remain relatively stable, according to a document released on Dec. 30.

federal reserve market

Records from the Federal Open Market Committee's Dec. 9-10 meeting showed that policymakers are increasingly concerned about the state of the short-term funding market, where banks and financial companies lend and borrow cash overnight. According to minutes of the meeting, officials pointed to several indicators of increasing pressure, including rising and volatile overnight repo rates, a widening divergence between market rates and the Fed's managed rates, and increased use of the Fed's standing repo facility.

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A central topic of discussion was the level of reserves in the banking system. The minutes said reserves had fallen to what the Fed considered “adequate” levels. However, several officials emphasized that the designation was a transition zone, not a buffer zone, and noted that if reserves are near the floor, modest swings in demand could push up overnight borrowing costs and strain funding markets.

Some participants compared the current situation to the Fed's 2017-2019 balance sheet drain, which ended with a spike in repo rates in September 2019. According to the minutes, officials suggested that current pressures may be building more rapidly than during previous episodes.

The minutes say staff projections indicate that reserves could decline significantly due to year-end balance sheet pressures, shifts in late January, and large spring outflows associated with the Fed's tax payments to Treasury accounts. Without intervention, these flows could push reserve levels below what policymakers consider comfortable, increasing the potential for disruption in overnight markets.

To reduce risk, participants discussed starting to purchase short-term Treasury securities to maintain sufficient reserves over the long term. The minutes of the meeting emphasized that these purchases support interest rate control and smooth market functioning, and do not signal a change in monetary policy stance. Survey respondents cited in the minutes expected these purchases to total about $220 billion in the first year.

Officials also explored ways to increase the effectiveness of the Fed's standing repo facility, which acts as a liquidity backstop. According to the minutes, participants discussed eliminating facility-wide usage caps and clarifying communications so that market participants view them as a routine part of the Fed's operating framework.

The target range for federal funds is currently 3.50% to 3.75%, and policymakers are scheduled to convene on January 27-28, 2026. CME Group's FedWatch tool shows that as of Jan. 2, traders had an 85.1% chance that rates would remain unchanged, compared to a 14.9% chance of a quarter-point cut.

Investors largely expected a quarter-point rate cut at the December meeting and were already pricing in another rate cut in 2026, according to market data. Interest rate expectations changed little during the meeting, according to minutes of the meeting.

The December minutes showed that policymakers were generally satisfied with the macroeconomic backdrop, but emphasized that liquidity management was a key priority alongside interest rate policy.

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