The Federal Reserve may have to slow or stop pruning its nearly $9 trillion balance sheet sooner than many now anticipate, a report from Barclays showed.
This investment bank’s analysts wrote this week that the current pace of the drawdown probably requires to change in the first half of 2023.
The reason comes because if the Fed decided to move ahead with letting its balance sheet contract, bank reserves would, by the end of next year, drop to levels that would make it difficult to maintain firm control of the federal funds rate, the U.S. central bank’s key tool for changing the direction of the economy.
Until now, Fed officials have offered little guidance as to how long and how far they intend to go with reducing the holdings, noting only that they see it as a prolonged process moving to an uncertain end. “I don’t know what the final endpoint is of our balance sheet,” Minneapolis Fed President Neel Kashkari said on Wednesday, but “we have a ways to go.”
The final stage of the process is complicated due to several factors. But the greatest uncertainty is that it is unclear when the financial system goes from ample levels of bank reserves to one where they are in short supply.
Scarce reserves indicate the federal funds target rate can become volatile, which central bankers do not like. When reserves declined in September 2019, the Fed was pushed to intervene to boost them through temporary liquidity injections and asset-buying.
The Barclays analysis takes place as the Fed is tightening its monetary policy stance on two fronts. Its bid to reduce inflation, which has been running at four-decade highs, is making officials ramp up their federal funds target rate range aggressively, with hikes likely to pour into next year.
Withdrawing stimulus has also meant pruning the size of the Fed’s balance sheet. From a scale of $4.2 trillion in March 2020, the holdings hit around $9 trillion as of last spring thanks to bond-buying stimulus efforts linked to the coronavirus pandemic.
In this context, the Fed began drawing down its holdings by $95 billion per month as of last month, with holdings currently at $8.8 trillion. Amid that fall, bank reserves have been shrinking.
The Barclays report said that because of changes in the financial system, total reserve levels are probably going to come under pressure at higher levels, which means “the current level of bank reserves is probably closer to reserve scarcity than might have been the case before 2015.”
Buy Crypto NowThe path the Fed is on now will probably trim just over $1 trillion from its balance sheet in 2023, which indicates reserves will become an issue for the monetary policy before the end of 2022, the report said.
“Our sense is that these changes to the shape and location of the demand curve for bank reserves will mean that the Fed reaches ‘ample’ much sooner than it expects,” hitting that mark in the first half of 2023, the report said.
The Barclays report recognizes the Fed could change the settings of its rate control toolkit or turn to other measures that could buy it some space on the reserves issue. But those sorts of things only provide a temporary respite, which makes changing the pace of the balance sheet drawdown the more beneficial tool.
