The phrase "central bank liquidity" usually means reserves available to the banking system. That quantity is not set by one dial. It is a balance between the central bank’s asset holdings and two large accounts that drain reserves out of the system.
net liquidity ≈ central bank assets − government cash balance − reverse repo balance
When the central bank buys assets it credits reserves. When the government collects more than it spends, cash moves into its account at the central bank and leaves the banking system. When money market funds park cash in the reverse repo facility, that also sits outside the banking system.
- Balance sheet expansion credits reserves to banks and adds liquidity.
- A rising government cash balance drains reserves — tax season is mechanically a drain.
- A rising reverse repo balance drains reserves; a falling one releases them back.
- The three move independently, which is why the balance sheet alone is a poor summary.
The central bank reduces its holdings by $60bn over a quarter — a drain. Over the same quarter the reverse repo balance falls by $200bn as money market funds move cash elsewhere — a release. The government cash balance rises by $50bn — a drain. The net effect is roughly +$90bn of reserves, despite the headline being "the balance sheet is shrinking".
Common belief
"Balance sheet up means risk assets up."
What is actually true
The correlation has been strong in some periods and absent in others. Liquidity is one input to the flow engine, and it interacts with real yields, the dollar and credit conditions. Treating it as a mechanical driver produces confident predictions that fail in exactly the regimes where being right matters.
This is the mechanism behind the upstream node of the VILIQ FLOW graph. Liquidity sits at tier zero because these balances change before their effects appear elsewhere — but the graph measures whether the downstream relationships are actually holding in the current window rather than assuming they do.