Is the Demand for T-bills Driving Treasury Deposits at the Fed?

By: Frank Shostak
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[Editor's note: Shostak employs a different measure of the money supply than the Rothbard-Salerno money supply measure used here. For a more full explanation, see here.]

On October 2016, the US Money Market Fund (MMF) industry underwent a reform with new requirements for US institutional prime and municipal MMFs becoming effective.

Under the new US MMF regulations, institutional prime and municipal MMFs are required to change from a fixed net asset value (NAV) to a floating NAV and adopt provisions to consider liquidity fees and redemption gates. However, government and Treasury MMFs were given a reprieve from these structural changes because of their perceived low risk and high liquidity.

RELATED: "Money Supply Growth Falls to 17-month Low in February

The changes that took place in October were announced two years earlier. In response to this since the end of 2015, there was a massive increase in the demand for Treasury bills. Consequently, government deposits, or the cash balances, with the Federal Reserve jumped from $75 billion in October 2015 to $394.6 billion by November 2016 — an increase of 426.1%. An increase in government deposits with the Fed reduces the supply of cash in the federal funds market, all other things being equal.

Consequently, this puts an upward pressure on the federal funds rate. In order to keep this rate at the target, which was set by Fed policymakers, the US central bank is compelled to lift the money supply by buying assets.

Note that while the increase in government deposits does not change the money supply, the Fed’s policy to protect the federal funds rate target results in an increase in money supply. Indeed the yearly growth rate in AMS jumped from 3.4% in October 2015 to 16.7% by November 2016.

Using our model, we forecast that government deposits are likely to follow a horizontal trend during 2017 to 2018. After closing at $323.9 billion in February, the level of deposits is forecast to close at $359 billion by December. By November next year, the level is forecast to climb to $445 billion before settling at $388 billion by December next year. According to our model, which incorporates the effect of government deposits among other variables, the yearly growth rate of AMS forecast is to close at 7% by December versus 8.5% in January before settling at 8% by December next year.