Federal Reserve officials feel their effort to cut the U.S. central bank’s bond holdings is far from done, opposing some economists’ idea that diminishing financial sector liquidity would end the drawdown in coming months.
Instead, Fed officials believe there remains a lot of liquidity, properly measured, for them to eliminate as part of their initiative to tighten financial conditions and knock down inflation.
These officials also observed the Fed at some point could even reduce short-term interest rates as it continues to shrink the almost $8.5 trillion balance sheet, and that such a move would not be at odds with wider monetary policy.
“I am confident that we have room to continue running off our assets for quite some time,” Dallas Fed President Lorie Logan said in a speech earlier in January. “Exactly how long that is will depend on a careful assessment of the financial environment.”
Logan’s view is important because she helped design and put into effect monetary policy as a top open markets official at the New York Fed before relocating to the Dallas Fed last summer.
The Fed increased the size of its balance sheet by two folds between March 2020 and last summer through aggressive purchases of Treasury and mortgage-backed debt that led the central bank’s holdings to increase at a record of around $9 trillion. The purchases aided to stabilize financial markets and provided economic stimulus beyond the near-zero interest rate policy introduced as the coronavirus pandemic struck.
In 2022, faced with a huge and persistent surge in inflation, the Fed forced the policy gears into reverse. In March, it started an aggressive campaign of rate hikes aimed at bringing inflation back to the Fed’s 2% target. In June, it also started to allow an increasing number of the bonds it owned to mature and not be replaced.
It now aims to offload just shy of $100 billion every month, and so far that approach has removed roughly $420 billion of bonds off the Fed’s balance sheet.
‘Could Get There In Short Order’
The problem now for the Fed, which is starting a two-day policy meeting on Tuesday, is how far to go. Removing too much liquidity could threaten control over short-term rates and trigger a rerun of the September 2019 market tumult that marked the end of its first balance-sheet shrinkage effort, also known as quantitative tightening.
Then, the Fed was compelled to intervene in markets and change course to restore bank reserves through renewed net bond purchases.
Fed officials and outside observers don’t see that occurring again. For one thing, Fed Chair Jerome Powell has already said he doesn’t intend to test how far the central bank can reduce reserves. Meanwhile, the Fed has a new and as-yet untested facility known as the Standing Repo Facility that can supply fast liquidity if financial institutions need it.
Logan, for one, said some turmoil in the drawdown would not be enough on its own to end the process. And as it now stands, Fed officials see plenty of liquidity for them to remove.
Since the Fed started hiking rates in March last year, reserves have shrunk from $3.9 trillion to $3 trillion now. This contraction, combined with regulatory issues and other considerations, had caused some analysts to speculate that a reserves shortage was imminent.
Some still hold the same opinion. Boris Senderovich, a fixed income analyst at Scotiabank, said in a note last week that reserves currently stand at nearly 13.3% of the U.S. gross domestic product. Right around 11% is the point at which they could start dwindling, and at the current pace of reserve contraction, he said, “we could get there in short order,” perhaps as soon as June.
Coexistence Of Rate Cuts, Drawdown
Fed officials increasingly consider liquidity as more than just bank reserves, a view that may expand the horizon for balance sheet cuts.
New York Fed President John Williams said in January that the around $2 trillion parked every day by money market funds and others in the Fed’s overnight reverse repo facility is the “key” to the outlook. As markets adjust to soaring interest rates, cash will begin to flow from this facility into the private sector and effectively restore reserve levels, giving the Fed the additional runway required to keep shrinking its holdings, he said.
Buy Crypto NowWilliams and Logan also hold the Fed can keep offloading bonds even when officials lower interest rates at some future date. In this scenario, the central bank could lower rates because inflation is subsiding sufficiently and a recalibration of monetary policy is justified. As this would not be an easing intended to provide stimulus to a weakening economy but a more neutral action, the Fed could continue balance sheet shrinkages.
“That’s not a shift in monetary policy, it’s just an adjustment in the stance of the policy due to the changing conditions,” Williams said. “So I would expect, you know, the process of balance sheet reduction to continue as it is.”
Fed officials have emphasized that their balance sheet reduction efforts are a background process, and at least one U.S. central banker sees slightly in the way of a market impact from allowing the process to continue for a while.
When the Fed announced its run-off plans in 2022, “all the interest rate effects from balance sheet tightening happened right away. And now all you’re doing is fulfilling those beliefs,” Fed Governor Christopher Waller said in January.
In the meantime, some of the analysts who had projected an early halt to the run-off have changed their opinions, even if are doubtful about the notion of rate cuts and balance sheet reductions running side by side. Still, Fed balance sheet reductions should “stay intact until early 2024,” analysts with forecasting firm LH Meyer wrote.
