Liquidity concerns are creeping into the Fed’s minutes as the use of repos increases.
Summary
- The December FOMC minutes show that officials are concerned that reserves are close to the lower limit of “adequate,” leaving funding markets vulnerable to shocks.
- Policymakers have been weighing government bond purchases and a more flexible standing repo facility to avoid a repeat of the 2019 repo rate spike.
- The markets still expect high chances of a stable rate at the meeting of January 27 and 28, 2026, leaving the fund margin at 3.50% to 3.75% for the time being.
The minutes of the Federal Reserve’s December policy meeting show concerns about potential liquidity shortages in the financial system even as interest rates remain relatively stable, according to documents released on December 30.
The Federal Reserve Market
Reports from the December 9-10 Federal Open Market Committee meeting show that policymakers are paying increasing attention to conditions in short-term funding markets, where banks and financial firms borrow and lend cash overnight. Officials noted that several indicators pointed to increasing pressure, including elevated and volatile overnight repo rates, widening gaps between market rates and Fed-administered rates, and increased use of the Fed’s standing repo facility, the minutes show.
Central to the discussion was the level of reserves in the banking system. The minutes said reserves had fallen to what the Fed considers “ample.” However, several officials emphasized that this designation marks a transition zone rather than a buffer, noting that modest fluctuations in demand could drive up overnight lending costs and put pressure on funding markets when reserves are near the lower limit.
Some participants compared current conditions to the Fed’s 2017-2019 balance sheet reduction, which ended with a sharp spike in the repo rate in September 2019. Officials suggested the current pressure may be increasing faster than during that earlier episode, the minutes show.
Staff projections show that pressure on year-end balance sheets, shifts in late January and a large drain in the spring due to tax payments flowing into the Treasury’s account at the Fed could significantly reduce reserves, the minutes said. Without intervention, these flows could push reserves below what policymakers consider comfortable, increasing the likelihood of disruptions in overnight markets.
To mitigate risk, participants discussed initiating purchases of short-term government bonds to maintain sufficient reserves over time. The minutes emphasized that such purchases would support interest rate control and the smooth functioning of the market, and would not signal a change in the monetary policy stance. Survey respondents listed 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 serves as a liquidity safety net. Participants discussed removing the facility’s overall usage limit and clarifying communications so that market participants consider it a routine part of the Fed’s operating framework, the minutes show.
The federal funds target range is currently 3.50% to 3.75%, with policymakers set to meet on January 27 and 28, 2026. As of Jan. 2, CME Group’s FedWatch Tool showed traders assigned an 85.1% probability that rates would hold steady, compared to a 14.9% probability of a quarter-point cut.
Investors had largely expected a quarter-point rate cut at the December meeting and had already priced in additional cuts in 2026, according to market data. Interest rate expectations changed little during the period between meetings, the minutes showed.
The December minutes showed that policymakers were generally comfortable with the macroeconomic backdrop, while liquidity management was highlighted as a crucial priority alongside interest rate policy.
