Fed's Williams: Will 'Monitor, Analyze' Liquidity Issues In Markets

New York Federal Reserve Bank President John Williams defended the moves to respond to a cash shortage that hit financial markets last week but said Monday the Fed will delve into the causes.

When the cash crunch worsened, clogging the plumbing for the US financial system, the Fed "acted quickly" and this "had the desired effect of reducing strains in markets," Williams said in prepared remarks.

But he acknowledged that the reaction was worse than expected.

As banks struggled to borrow enough funds to meet their daily cash reserve requirements, the New York Fed was forced to step in starting September 17 to tamp down interest rates by providing daily cash infusions to clamp down on rising interest rates.

The episode highlights "the vital role that the Federal Reserve plays in supplying liquidity to the system when markets are under stress," Williams said.

"We were prepared for such an event, acted quickly and appropriately and our actions were successful."

But he said it remains important to "examine these recent market dynamics" that led to the situations, and "we will continue to monitor and analyze developments closely."

The comments came as the Fed continued to offer $75 billion in short-term cash loans to banks to ensure they have enough reserves to meet the minimum requirement.

However, in a sign that the liquidity shortage may be easing, on Monday, the fifth day of emergency cash injections, the New York Fed received requests for only $65 billion.

Williams said the Fed was expecting some issues at the end of the quarter as an array of conditions converged to dry up liquidity in the banking system -- including quarterly corporate tax payments and a surge in government debt sold to investors, which drained cash out of banks.

As a result, short-term interest rates were rising sharply, outside of the Fed's desired range.

Surprising reaction

Williams acknowledged that while the Fed was expecting issues, they were somewhat caught off guard since "the size of the reaction in repo rates, the spillover to unsecured markets such as federal funds, and the emergence of strains in market functioning were outside of recent experience."

It became clear last week that "markets were not effectively distributing liquidity across the system" and the situation "had the potential to become more acute," he said.

After four days of so-called repo operations -- in which Fed exchanges assets like Treasury debt for cash -- the New York Fed announced Friday it would conduct the liquidity injections daily through October 10.

Banks borrow regularly in markets for very short periods, usually overnight, to make sure their daily cash reserves do not fall below the required level. But interest rates increase with demand.

The New York Fed adds or removes liquidity to keep interest rates in line with the desired target range.

But some economists and Fed observers say it is concerning that the system got so out of whack.

And some have wondered whether the departure earlier this year of longtime head of market operations, Simon Potter, played a role.

Potter and another senior executive in charge of the financial services group stepped down on June 1 and their positions have not been filled.