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Central bank officials are expected to discuss ways to slow the Federal Reserve’s balance sheet shrinkage this week, but little-known strategies the central bank is using to tighten financial conditions while fighting inflation are on the rise. It is a policy tool that does not exist.
Over the past two years, the Fed has released about $1.5 trillion in Treasury and mortgage bonds that it had accumulated in an effort to stimulate the economy early in the pandemic, at a rate of about $100 billion a month.
Allowing these bonds to mature would push up long-term interest rates because other investors would have to buy more bonds.
This so-called “quantitative tightening” (QT), along with a series of hikes in the Fed’s benchmark federal funds rate, is a key tool the central bank is using to rein in the hottest inflation since the 1980s.
Now that inflation is declining, the question is when the Fed will start slowing the pace of balance sheet drains.
What the Fed wants to avoid is the kind of turmoil in financial markets that occurred the last time the Fed tried to shrink its balance sheet at the end of 2010.
Dallas Fed President Laurie Logan, who oversaw the Fed’s last balance sheet reduction in 2019 while at the New York Fed, said, “Moving more slowly reduces the risk of accidents that require premature shutdowns.” Ta.
“This strategy reduces the risk of undesirable liquidity stress due to QT.”
“Sufficient” reserves
When will this slowdown begin? It will depend on the level of money market reserves held by the Fed, known as the Overnight Reverse Repurchase Program (ON RPP), which are separate from the funds that end up in bank reserves. It may depend.
ON’s RPP facility is shrinking, and some Fed officials want to slow outflows once the facility is nearly depleted.
Mr. Logan said that as long as ON’s RRP facility has significant balances, officials can be confident that there is more than enough liquidity. However, once the ON RRP is empty, there is further uncertainty as to how much excess liquidity remains.
New York Fed President John Williams said that at the onset of an economic slowdown, balances should be slightly above what the Fed considers to be consistent with “adequate” reserves, a level that would allow the Fed to continue controlling short-term interest rates. He said it would be time. Increase interest rates and avoid volatility in money markets.
“I don’t think you can specify in advance a sufficient level,” Logan said in a recent speech. “We’re going to have to figure it out, watching the spreads and volatility in the money markets.”
For Logan, that means monitoring the spread between money market interest rates and the interest rate on bank reserve balances.
If foreign exchange reserves are sufficient, interest rates in the money market should not change much even if the supply of foreign exchange reserves changes. However, if reserves are less than ample and money market interest rates are significantly higher than interest on reserve balances, banks face an implicit tax on liquidity.
This can make the financial system less secure and less efficient. “A more gradual approach could give banks time to adjust and ultimately allow the Fed to arrive at a smaller balance sheet,” Logan said.
From QE to QT
Before there was QT, there was QE, or “quantitative easing.”
It began in late 2008 under Fed Chairman Ben Bernanke, when the Fed first began buying large amounts of bonds to provide much-needed stimulus to an economy then in the throes of a devastating financial crisis.
Eventually, it implemented two more rounds of quantitative easing, known as QE2 and QE3, which drew criticism from observers who argued that the programs were responsible for speculative bubbles and market bubbles.
The Fed has tried QT once before, starting in 2017 when Janet Yellen was head of the central bank. However, portfolio shrinkage depleted the central bank’s reserves, causing unexpected disruption.
After Mr. Powell took over at the Fed in 2019, a cash crunch created a spike in interest rates on short-term “repo” loans that banks make to each other. In response to this turmoil, the Federal Reserve resumed purchasing, and the market calmed down.
Its buying increased aggressively in 2020, when the pandemic began, as a way to further stimulate the economy and ease financial conditions.
The Fed’s securities holdings reached $9 trillion in 2022, the year it decided to reverse course and act aggressively to curb rising inflation.
Since QT began about two years ago, the Fed’s balance sheet has been stretched to about $7.5 trillion as regulators have prevented just under $100 billion a month in Treasury and mortgage bonds from being replaced as they mature. Shrunk.
“Not enough shoot-ins”
Fed officials see QT and interest rates on different trajectories. Fed President Chris Waller said changes to the Fed’s balance sheet would be independent of rate cuts.
“Balance sheet planning is about getting the liquidity level right and approaching ‘abundance’ at the right speed,” Waller said in a speech on March 1.
“They do not suggest anything about an interest rate policy stance that is focused on influencing the macroeconomy and achieving our dual mandate.”
Waller said he, like other officials, wants the Fed’s holdings of mortgage-backed securities to drop to zero and for the Fed to have a balance sheet dominated by Treasury securities.
Former St. Louis Fed President Jim Bullard and former Kansas City Fed President Esther George both said they did not expect any balance sheet decisions to be made at the meeting.
“I think what they’re trying to avoid is running into the problem they’ve had before and getting too close to the demand for reserves and causing some problems with market functioning,” George said.
But Piper Sandler analyst Benson Durham said he expects Fed officials to begin tapering the pace of balance sheet outflows at their next meeting in a policy statement this week. “No, but it’s very possible.” .
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