(Reuters) -A day ahead of what is expected to be very volatile conditions in money markets, a top Federal Reserve Bank of New York official said on Monday that markets are still flush with liquidity, central bank tools are in place to manage temporary hiccups, and in any case some level of chop in money market rates is healthy.

"Our indicators currently suggest that reserves are still abundant," said Julie Remache, deputy manager of the bank's System Open Market Account and Head of Market and Portfolio Analysis. Her comments indicate she does not see a looming need to end the process of shrinking Fed holdings in an effort called quantitative tightening, or QT. She did note there has been some "firming" of repo rates, and ongoing QT may lead to keeping those rates up over time.

Remache spoke ahead of quarter end, generally a time of heavy volatility in money markets. Those periods are often associated with shortages of liquidity and higher money market rates, pressures that usually abate in short order. But the current period is more fraught due to Fed actions. 

Since 2022, the Fed has been allowing a set amount of bonds it owns to mature and not be replaced as it seeks to remove from the financial system the ocean of cash it added to markets to stabilize trading and stimulate the economy during the COVID-19 pandemic and its aftermath. Fed holdings more than doubled to a peak of $9 trillion and have since ebbed to $6.7 trillion. 

Thus far, the contraction of liquidity has primarily taken out cash that markets did not need. From a peak of $2.6 trillion at the end of 2022, the Fed's overnight reverse repo facility has in recent weeks shrunk to negligible levels. As QT moves forward it will now start to remove what have been steady levels of reserves, which increases the chance of unexpected pressure in the market. 

With the QT process now eating into underlying levels of liquidity, markets are speculating about how much further the process can continue. They are also expecting Fed liquidity facilities to get big action on Tuesday. Wrightson ICAP has penciled in as much as $300 billion in reverse repo inflows as market participants look for a short-term parking place for cash.

SRF ARRIVES

What will be more notable is what happens with the Standing Repo Facility, or SRF. Created in 2021 to provide cash loans in exchange for bonds, this Fed tool is designed to be a short-term shock absorber for liquidity shortfalls, allowing the Fed to watch longer-term trends when pressing forward with QT. The SRF also allows the Fed to shy away from interventions in markets to manage liquidity. 

The challenge is that thus far, the SRF has seen little real-world usage. That is almost certain to change on Tuesday. Wrightson sees potential inflows of around $50 billion.

Some in markets are unsure whether the SRF can do the job the Fed expects it to perform.

Scott Skyrm of money market trading firm Curvature Securities said market rates are already above what it costs to borrow from the Fed, which should make SRF usage attractive, but it might now work when market participants are pulling back on their balance sheets.

He noted the current 4.25% spread between general collateral repo and the SRF is very wide and should already be pushing firms to borrow cash from the Fed. The fact that this is not happening "means the market has no confidence that the SRF will do its job," Skyrm said. 

Some have also worried that some eligible firms may be afraid that using SRF would signal weakness, even though Fed officials have encouraged use of the tool. Those who use the SRF will have their names publicly revealed in two years, as required by law. 

In her speech, Remache cautioned that the Fed will not be surprised by potential churn. She said that even though the central bank's rate control is working and strongly influencing the setting of interest rates generally, "money market rates still vary, and tend to rise on key reporting dates, including quarter ends, as banks optimize their balance sheets."

This firming of rates around the quarter end "is - within limits - normal, not concerning, and exactly what we expect as we continue to normalize our balance sheet."

On the SRF, Remache said the facility "can stem incipient rate pressure that, if left unaddressed, could threaten rate control."