(Bloomberg) – Hidden in hours of congressional testimony by Federal Reserve Chairman Jerome Powell last month was an admission that the central bank had been blindsided by the impact of shrinking its balance sheet there. four years ago.
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While Powell assured lawmakers the Fed is committed to avoiding a repeat of 2019 — when the repo market, a key part of America’s financial plumbing, seized up — Wall Street economists and strategists warn that quantitative tightening remains complex and difficult to predict. Known as QT, this involves letting Fed bond holdings mature without replacement, draining liquidity from the financial system.
In the coming months, the current Fed QT program should take its toll. How this happens and how the Fed handles the process could shape its policy leeway to continue to use its track record as a key tool going forward, amid the Republican angst that surfaced during the hearings of Powell on June 21 and 22.
“We didn’t see it coming,” Powell admitted to the House Financial Services Committee on June 21, referring to sudden problems that surfaced in 2019 and forced the central bank to take action it would not. The advantage now is “we have experience,” he says.
The Fed is currently shedding its bond holdings at an annual rate of about $1 trillion, much faster than in 2019, but from a much broader base. Powell told lawmakers he was “very aware” of the importance of not just inflating the balance sheet with each round of easing and leaving it enlarged.
So far, Powell and market participants agree that things are going well. There are still over $3.2 trillion in bank reserves parked at the Fed, and there is no indication that this gauge of liquidity has shrunk to a level that would cause problems in money markets as happened in 2019. Analysts estimate – with little conviction – the banking system needs at least $2.5 trillion to function properly.
“You don’t want to find yourself, like we did a few years ago, suddenly discovering that supplies were scarce,” Powell said last month. This time, the goal is to slow down QT at some point, ending bond portfolio trickle when reserves are still “abundant”, with an additional buffer “so we don’t accidentally run into a shortage of reserves. “.
One of the reasons things are going well so far is that there’s another important piece of liquidity on the Fed’s balance sheet – the reverse repo facility. Known as RRP, money market funds used it to park cash. And that account is over $1.8 trillion.
Overall impact
Another reason is that the Fed’s overall balance sheet has shrunk only a fraction of the amount it has grown during the pandemic. The Fed’s liquidity injections in the spring – to help solve the problems of regional banks – have expanded the balance sheet. The Treasury was also limiting bond sales – which suppressed liquidity – as it was constrained by the impasse over the debt limit.
However, both of these dynamics are largely over now.
“Things will start to tighten on the liquidity side,” predicted Raghuram Rajan, the former chief economist of the International Monetary Fund and governor of India’s central bank. “So we’ll see all the consequences” of QT, the University of Chicago economist told Bloomberg Television last week.
Even then, a number of observers see things going relatively well. This is because QT might end up draining mostly RRP. Indeed, it has already retreated to the lowest level since May 2022.
Powell’s preference
The RRP can decline “significantly” without “particularly large macroeconomic effects,” Powell explained last month. And he told a Senate panel that “that’s what we would have hoped to see, rather than taking reserves out of the system.”
As the Treasury is in the process of increasing its own cash reserve to $1 trillion, market participants will be keeping a close eye on how much will be depleted as it goes.
Bank of America Corp. strategists, led by Mark Cabana, estimate 90% of Treasury issuance will be funded by the RRP, as money market funds shift from that Fed facility to investments in Treasuries at higher yield.
Others are not so sure.
The doubts of others
RBC Capital Markets analysis indicates that, so far, around 60% of Treasury sales have come from draining the RRP. Even that pace is faster than Blake Gwinn and Izaac Brook predicted, and those strategists see the rate slipping to 45% to 50%. If households and businesses continue to pour cash into money market funds, they say, it could force them to keep large sums in the RRP, slowing its decline.
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Gennadiy Goldberg, head of U.S. rates strategy at TD Securities Inc., said it was unclear how the Treasury bill sales would be funded. And that in turn leaves the impact of the Fed’s QT in a question mark.
“Saying everything is fine is like calling off the game after the first quarter,” he said. “Last time the Fed hit the wall at 60 mph because it didn’t expect the reserve shortage to be there – and the risk is again worth watching.”
There are other potential problems, to boot.
Dina Marchioni, director of money markets at the New York Fed, told a symposium last month that staff were watching the potential for money market funds to start buying slightly longer-dated assets — something they could do to lock in yields longer as the Fed nears the end of interest rate hikes.
Tools available
That could put upward pressure on very short-term rates, sending them above the Fed’s target rate, Marchioni said.
The central bank has policy tools it can use to address the challenges, including a permanent repo facility that offers overnight liquidity in exchange for securities, and the recently created bank term funding program.
“The risk scenario is that they do too much, too fast, and then disrupt the flow of credit to the economy so much that it tips things into recession,” said Seth Carpenter, a former Treasury official who is now Global Chief Economist at Morgan Stanley. But “that’s not our base case at all,” he added, expecting QT to last until next year.
Yet even Fed staff – as minutes from the last policy meeting revealed – last month viewed with “uncertainty” their expectation that bank reserves would remain “abundant” by the end of the year. .
“The biggest unknown at the moment is what is the lowest comfortable level of reserves in the financial system,” said TD’s Goldberg. “We just don’t know.”
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