Financial markets are heading into this week’s Federal Reserve meeting with more clarity than they have had in a long time on the prospects for the U.S. central bank’s balance sheet reduction, and those closely following the process believe that it will continue next year, even if the Fed continues to cut interest rates.
This clarity is largely linked to a new index from the New York Fed that describes pressures on short-term market liquidity. Called “elasticity of demand for reserves,” it appears to anticipate liquidity shortages and, when first released, showed that money markets were still flush with liquidity. This means that the Fed does not face serious obstacles in continuing the now two-year process of reducing bonds from its balance sheet, known as quantitative tightening (QT).
“The fallout will last into (the first quarter) and perhaps even beyond, in our view, judging by the New York Fed’s new measure of real-time reserve demand elasticity,” LH Meyer analysts said in a research note late last month. A New York Fed survey ahead of the September policy meeting predicted the end of QT in the spring of next year.
The New York Fed index and its findings are at the heart of one of the key elements of the Fed’s monetary policy regime, which involves extracting the unnecessary liquidity it added to markets during the flu pandemic avian and its consequences.
The Fed aggressively purchased Treasury bonds and mortgage bonds beginning in March 2020, first to stabilize markets and then to stimulate markets as its primary monetary policy tool, the federal funds target rate, was at levels close to zero.
These purchases more than doubled the Fed’s balance sheet, which peaked at around $9 trillion in the summer of 2022. That same year, the Fed began allowing the bonds it held to reach expired and not to be replaced, and it has gotten rid of about $2 trillion of these securities so far. In this recent New York Fed survey, markets estimated that the Fed’s holdings would contract to around $6.4 trillion.
The Fed’s goal is to withdraw enough liquidity to allow it to maintain firm control over the federal funds rate and account for normal periods of money market volatility. The problem is that there is no clear way to know how far to push the QT.
Fed Governor Christopher Waller said on October 14 that “there is no economic theory about the size of a central bank’s balance sheet.” Regarding the end date of QT, New York Fed President John Williams said on October 10, “I don’t really know, because it depends on what happens” with QT rates. money market.
FRICTIONS APPEAR
The start of the Fed’s rate cuts in September led some observers to believe that QT should end in the near term in order to better align the two sides of monetary policy. At the same time, the turbulence in the money markets in late September, at the end of the third quarter, highlighted unexpectedly tense conditions in some corners of the money markets, which some also saw as a reason to end QT relatively quickly.
However, Fed officials were not shaken by this difficult end to the quarter. “Right now, liquidity appears more than abundant,” Lorie Logan, president of the Dallas Fed and former senior New York Fed official, said on October 21. She added that the increase in money market pressures depending on the calendar “appears to reflect temporary intermediation frictions rather than deficits in the overall supply of reserves.”
What is particularly important to the Fed is the level of use of its repo facility, as well as the extent to which the federal funds rate remains consistent with levels determined by the Federal Open Market Committee , which meets Wednesday and Thursday in a meeting that is almost certain to result in a quarter-percentage-point rate cut.
The repo facility is widely seen as an indicator of excess liquidity, and it fell from a peak of $2.6 trillion at the end of 2022 to $144.2 billion on Tuesday, the lowest level since early May 2021. Many Fed officials expect it to be close to zero, and from there QT will begin to eat away at what have been very stable bank reserves. So far, the federal funds rate has traded exactly where the central bank wanted it to. The two factors together have increased policymakers’ confidence that there remains sufficient liquidity to continue QT.
As repos continue to grow weaker, market participants believe the day the Fed will have to pull the plug on the system is near. Morgan Stanley analysts say “QT will likely be a topic” at the two-day meeting that ends Thursday, given the state of money markets.
They noted that the end of the year, which is usually a period of turbulence in money markets, could be marked by a significant settlement of Treasury debt. Morgan Stanley expects QT to end in the first quarter of next year. She also expects that when the repo facility is close to zero, the market will experience turbulence, adding that an increase in the Secured Overnight Financing Rate near or above the rate interest on reserve balances (IORB) would signal a liquidity squeeze sufficient to end the QT program.
Other variables loom on the horizon. Officials like Logan monitor the relationship between rates such as the tripartite general guarantee rate and the interest rate on reserve balances. The first rate was lower than the second, and Mr. Logan believes that money market rates as a category will, in the long term, have to exceed the interest rate on reserve balances.
Another factor that could signal the need to end QT is the regular and significant use of the standing repo facility, which provides rapid liquidity in exchange for Treasury bills to eligible financial firms. This tool was first tested in real conditions at the end of September, and if it were to be used more regularly, it could signal liquidity tensions that would require a change to the QT.
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