(Bloomberg) — As the Federal Reserve contemplates slowing the runoff of its balance sheet fairly soon, Wall Street is honing in on what level of bank reserves is appropriate to guarantee liquidity and avert past blowups in financial markets.
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The Fed has been winding down its holdings of Treasuries and mortgage-backed securities — a process known as quantitative tightening, or QT — at a rate of $95 billion per month. Chair Jerome Powell said Wednesday the Fed’s considering slowing the pace to “help ensure a smooth transition, reducing the possibility of money markets experiencing stress.”
Bank reserves, cash that institutions park at the Fed to meet unexpected demands, stand at $3.5 trillion. That’s a level policymakers characterize as abundant, and they’re aiming for ample, Powell said in the post-meeting press conference, describing it as “a little bit less” than abundant.
Therein lies the problem: Identifying where that ample level actually lies and avoiding an unexpected funding scarcity, according to Barclays Plc strategist Joseph Abate, who puts that empirical level somewhere between $1.4 trillion — the point of scarcity in 2019 — and $3.5 trillion.
If the Fed lets reserves shrink too much it risks triggering ructions in overnight funding markets as was seen in September 2019. However, too many reserves consume bank capital and inhibit lending, and ensure the Fed bank maintains a large footprint in the Treasury cash and repo markets.
“Determining the level of ample reserves involves a bit of risk balancing,” Abate wrote in a note to clients on Thursday. “It needs to balance the risk of accidentally discovering the minimum comfortable level of bank reserves against the risk of maintaining an overly large balance sheet by stopping QT too soon.”
During the last QT cycle that began in 2018, the central bank was letting as much as $30 billion in Treasuries and as much as $20 billion in agency-backed mortgage debt run off before it decided to start slowing that pace the following year.
But by the time the Fed did so, market pressures were already evident.
The combination of increased government borrowing and a corporate tax payment created a shortage of reserves in September 2019, driving a five-fold surge in a key lending rate and a spike in the federal funds rate above the target range. The Fed was forced to intervene and buy Treasury bills to increase the amount of reserves.
This may be why some officials like Dallas Fed President Lorie Logan have been in favor of slowing the asset runoff fairly soon as Powell indicated on Wednesday, because it would allow the central bank to continue shrinking the balance sheet while cautiously nearing the optimal level of reserves without tipping into scarcity.
Read more: Powell Says It’ll Soon Be Appropriate to Slow Pace of QT
This approach could actually extend the amount of time the Fed can roll off its balance sheet. While Barclays sees risks of QT running into the first quarter of 2025, its base case is the unwind ending at the end of 2024.
For Abate, the chances of such a disruptive spike are lower this time around now that the Fed has a “wider safety net” that includes the discount window and the Standing Repo Facility, where banks can lend Treasuries and government agency debt in exchange for cash, he said.
On the flip side, halting QT too soon and keeping bank reserves close to abundant levels pose risks to the financial system: The Fed’s elevated engagement in the Treasury and repo markets limits its flexibility in responding to crises, while parking excess bank funds in reserves curb lending that helps drive economic growth.
Ultimately, Abate contends there’s a more philosophical debate that all central banks must wrestle with in their policy decisions as they exit QT.
“By maintaining a large balance sheet, is the Fed accommodating excessive bank demand for reserves?” he said. “Would a smaller balance sheet with fewer reserves encourage banks to hold more Treasury HQLA (high-quality liquid assets) instead and perhaps become more efficient in liquidity management?”
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