Ca central bank Make $2.5 trillion in cash disappear without anyone noticing? That’s the unlikely, even bold, mission the Federal Reserve has embarked on in an attempt to shrink its vast balance sheet while minimizing disruption to the economy. The process – known as “quantitative tightening” (quart) – started in mid-2022. The Fed has already shed almost $500 billion in assets, a good first step. But recent ripples in the banking system point to impending turmoil. Some analysts and investors believe these tensions will ultimately force the Fed to exit quart way ahead of schedule. Others suspect the central bank still has time and tools on its side.
It may sound like a technical and obscure debate. It’s certainly complex. But it also goes to the heart of modern monetary policy. Like other central banks, the Fed is now using quantitative easing (qe) – Purchase of assets, especially government bonds, on a large scale – to calm financial markets and stimulate the economy in severe downturns. For qe work in the future quart must work now: Expanding balance sheets in bad times is only sustainable if they shrink in good times, otherwise they keep getting bigger.
The Fed has resorted to it since the global financial crisis of 2007-09 qe on four occasions, leading to a body of research on how it works. The Fed has acted against this quart only once, from late 2017 to 2019, did it stop prematurely after the money market began to buckle. There is therefore a great deal of uncertainty about the consequences.
A superficially appealing way of thinking about it quart is as qe in reverse. As well as qe involves creating central bank reserves to buy bonds, ie quart involves removing reserves when the central bank reduces its holdings. And the same qe helps keep long-term interest rates low, ie quart raises them. Researchers estimate that reducing the Fed’s balance sheet by about $2.5 trillion over a couple of years has about the same effect as raising interest rates by half a percentage point.
Many think this has already happened as the market raised long-term rates as the Fed set rates quart plans last year. Christopher Waller, a Fed governor, has argued that now that investors have priced in the announced cuts, the Fed is simply performing: “The balance sheet is just kind of running in the background.” Fed officials have said quart should be about as exciting as watching paint dry.
The problem with the analogy is that the paint gets drier and drier, quart becomes more and more treacherous. This is also a key difference qe. If the economy is in good shape, central banks can gradually step back qe. In the case of quartthere is a risk that the Fed will only realize through market turbulence that it has gone too far, as it did in 2019. First quart pulls money out of a liquidity-deluged commercial banking system; However, as we move forward, liquidity will become tighter and the cost of funding for banks can skyrocket without much warning.
A preview of the possible burdens has taken place in the past few weeks. Some banks that have recently lost deposits have turned to the federal funds market to borrow reserves from other lenders to meet regulatory requirements. Daily borrowing in the fed fund market averaged $106 billion in January, with most data going back to 2016. So far, the squeeze has been limited to smaller banks, a hopeful sign that the financial system is returning to its pre-pandemic state. where big banks lend money to their weaker competitors. Nevertheless, the question arises as to whether and when other banks will run into refinancing bottlenecks.
The notion that a crisis is far away is supported by a look at the Fed’s liabilities. About $3 trillion is the banks’ reserves (actually deposits with the central bank). Another $2 trillion is money from firms entering into Treasury bond exchanges with the Fed (such overnight reverse repurchase agreements, or reverse repos, allow them to earn a small return on their excess cash). Mr Waller said that quart should run smoothly until bank reserves hit about 10% bip, when the Fed will slow its balance sheet reductions to try to right-size the financial system. If reserves and reverse repos are interchangeable, as Mr Waller suggests, then reserves are now 19% bip, leaves a lot of space. Therefore quart could go on for a few more years, hurting a large chunk of the Fed’s balance sheet in the process.
But even before that, problems can arise. First, banks are likely to need more reserves than they did before Covid-19 because their assets have been growing faster than the rest of the economy. Second, and crucially, reverse repos and reserves may not actually be interchangeable. Much of the demand for reverse repos comes from money market funds, which act as an alternative to bank deposits for companies looking for slightly higher yields. If this demand continues, the weight of quart will instead weigh more heavily on bank reserves. In that scenario, reserves could run out before the end of this year, strategists at T. Rowe Price, an investment firm, think. The Fed’s balance sheet would be stuck at around $8 trillion, nearly double what it was before the pandemic. This would raise concerns about its ability to get started qe in the future.
Oddly enough, the mess over the debt ceiling could mask any unrest over the next few months. Unable to borrow until Congress raises the debt ceiling, the Treasury Department is reducing its cash holdings with the Fed. When the money leaves the Treasury account, much ends up in the banking system, which in turn helps banks replenish their reserves.
But if Congress gets around to raising America’s debt ceiling, the Treasury Department will have to increase its borrowing. For banks, this can mean a rapid loss of reserves. The Fed created a credit facility to alleviate such shortages. However, there is no telling how it will perform in the wild, making the course even more uncertain quart. The market may be quiet for now. It is unlikely that this will remain the case. ■
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