by (Bloomberg) — Tucked away in hours of congressional testimony by Federal Reserve Chairman Jerome Powell last month was an admission that the central bank was blindsided by the impact of shrinking its balance sheet four years ago.
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While Powell assured lawmakers that the Fed is determined to avoid a repeat of 2019 — when the repo market, a key part of U.S. financial plumbing, stalled — Wall Street economists and strategists warn that quantitative tightening remains complex and difficult to predict . Known as QT, it involves the Fed bonds maturing without replacement, taking money out of the financial system.
The effects of the Fed’s current QT program will be fully felt in the coming months. How things move forward and how the Fed handles the process could determine its political leeway to continue using its balance sheet as an important tool going forward, amid the Republican fear seen in Powell’s 21 hearings. -June 22.
“We didn’t see it coming,” Powell admitted to the House Financial Services Committee on June 21, referring to the sudden troubles that surfaced in 2019 and forced the central bank to take steps it didn’t want. The advantage now is “we have experience,” he said.
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 larger base. Powell told lawmakers he is “very aware” of the importance of not just inflating the balance sheet during each easing cycle and leaving it magnified.
So far, Powell and market participants agree that things are moving smoothly. More than $3.2 trillion in bank reserves are still parked at the Fed, and there’s no indication that that gauge of liquidity has dwindled to a level that would cause problems in money markets, as it did in 2019. Analysts estimate – with little conviction – the banking system needs at least $2.5 trillion to function smoothly.
“You don’t want to suddenly discover, like a few years ago, that reserves were scarce,” Powell said last month. This time, the goal is to slow down QT at some point, ending bond portfolio outflow when reserves are still “abundant,” with an additional buffer “so we don’t accidentally run into reserve scarcity.”
One of the reasons it’s going well so far is that there’s another big element of liquidity on the Fed’s balance sheet: the reverse repo facility. Known as RRP, money market funds have used it to park money. And that account stands at over $1.8 trillion.
Full impact
Another reason is that the Fed’s overall balance sheet has shrunk only a fraction of the amount it increased during the pandemic. The Fed’s liquidity injections in the spring – to address regional banking problems – have increased the balance sheet. The Treasury also restricted bill sales – which drain liquidity – while being constrained by the debt limit impasse.
However, those two dynamics have now largely come to an end.
“The liquidity side will tighten,” predicted Raghuram Rajan, former chief economist of the International Monetary Fund and governor of India’s central bank. “Then we will see the full impact” of QT, the University of Chicago economist said on Bloomberg Television last week.
Even then, a number of observers see that things are going relatively smoothly. That’s because QT could eventually deplete mostly RRP. Indeed, it has already fallen to its lowest level since May 2022.
Powell’s preference
The RRP could contract “drastically” without “particularly significant macroeconomic effects,” Powell explained last month. And he told a Senate panel that “that’s what we hoped to see, rather than taking reserves out of the system.”
With the Treasury working to boost its own cash reserve by as much as $1 trillion, market participants will be watching closely what is drained over time.
Bank of America Corp. strategists, led by Mark Cabana, estimate that 90% of Treasury issuances will be funded by the RRP as money market funds shift from that Fed facility to investments in higher-yielding T-bills.
Others are not so sure.
Doubts of others
RBC Capital Markets analysis indicates that approximately 60% of Treasury revenue to date has come from RRP deflation. Even that pace is faster than Blake Gwinn and Izaac Brook expected, and those strategists are seeing the percentage drop to 45% to 50%. If households and businesses continue to deposit cash into money market funds, they say, they would still have to park large sums in the RRP, slowing its decline.
Read more: money markets give the Fed room to continue to divest Treasury bills
Gennadiy Goldberg, head of US interest rate strategy at TD Securities Inc., said it was unclear how the sale of Treasury bills will be funded. And that, in turn, leaves the impact of the Fed’s QT a question mark.
“Saying everything is fine is like calling off the game after the first quarter,” he said. “The last time the Fed hit the wall at 60 mph because they didn’t expect reserve shortages — and the risk is now once again to watch out for.”
There are other potential problems to boot.
Dina Marchioni, director of money markets at the New York Fed, said at a symposium last month that staff look to the opportunity for money market funds to start buying assets with slightly longer maturities – something they could do to hold onto yields longer as the Fed nears the end of rate hikes.
Tools available
That could put upward pressure on overnight interest rates, pushing them above the Fed’s target rate, Marchioni said.
The central bank does have policy tools it can use to meet challenges, including a standing repo facility that offers overnight cash in exchange for securities, and the recently established 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 in such a way that it pushes things into a recession,” said Seth Carpenter, a former Treasury official who is now chief global economist at Morgan Stanley. But “that’s not our base case at all,” he added, expecting QT to last well into next year.
Yet even Fed officials last month — as evidenced by the minutes of the most recent policy meeting — viewed with “uncertainty” their expectation that bank reserves will remain “abundant” by the end of the year.
“The biggest unknown right now 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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