Fed’s QT Could Run Another Few Quarters

Summary

• The high costs of a large balance sheet means the Fed seeks the lowest reserves still consistent with low FFR responsiveness to short-term changes in demand or supply.
• The Fed has slowed QT even though reserves have not decreased yet due to its limited control over reserves and due to demand uncertainty.
• On current trends, QT could have another 3-4 quarters to run before reserves become ample, though there is considerable uncertainty.

Market Implications

• The market impact of QT is likely to be limited as the Fed intends to stop before reserves scarcity.
• I still expect one 2024 insurance cut at the November or December FOMC against markets pricing 2.5 cuts by December and a 98% probability of a cut in September.

Fed Reserves: Less Is More

In this note, I discuss how long QT could keep running and the market implications.

QT started in June 2022. Its purpose is to move the quantity of reserves from abundant to ample. That is, to reduce the quantity of reserves but keep them high enough so that a short-term change in the supply or demand of reserves does not impact the FFR.

The Fed prefers to operate with ample rather than abundant reserves largely because of high interest payments. In 2023, net interest expenses were $106.6bn, compared with net interest income of $67.8bn in 2022. In addition, compared with 2017-19, this time QT has been accompanied by curve inversion, which has led to outright Fed losses (Chart 1).

In theory, operational losses do not prevent a central bank from functioning. In practice, they can harm credibility and undermine independence. Large interest payments to banks, as well as losses, could be politically contentious.

The Limits of Fed Reserves Control

Since May 2022, the balance sheet has shrunk $1.7tn to $7.2tn (Chart 2). On the asset side, most of the shrinkage has come from the Treasury securities portfolio, which fell $1.3tn to $4.4tn. Meanwhile, agencies’ MBS fell $0.4tn to $2.3tn. Because of the gap between rates on existing mortgages and market mortgage rates, there have been few prepayments and the reinvestment ceilings on MBS have generally not been binding.

At the 1 May meeting, the FOMC announced QT tapering. This is the reduction of the monthly redemption cap on Treasury securities from $60bn to $25bn while maintaining the monthly redemption cap on agency debt and agency MBS at $35bn.

The Fed further stated that ‘the decision to slow the pace of runoff does not mean that our balance sheet will ultimately shrink by less than it would otherwise but rather allows us to approach its ultimate level more gradually and reduce the possibility that money markets experience stress’.

This greater caution reflects that the Fed has limited short-term control over the quantity of reserves. For instance, non-reserves liabilities (e.g., TGA or foreign RRP) can be volatile. Reserves can change without a change in the asset side of the Fed balance sheet.

In September 2019, a bout of money market volatility surprised the Fed. It was caused by large Treasury issuance and corporate tax payments compounded by banks’ reluctance to lend to each other (settlements of Treasury purchases and tax payments increase the TGA and lower the quantity of reserves). Given TGA volatility on the lack of interbank lending, the quantity of reserves in the system turned out too small.

This time, QT has shown that the relationship between Fed assets and reserves reflects in part factors beyond the Fed’s control. The $1.8tn decrease in Fed assets since mid-2022 has been largely offset on the liabilities side of the balance sheet by a decrease in the RRP, which is now down to $0.4tn from a peak at $2.3tn. Reserves, at $3.3tn, are actually unchanged from mid-2022.

The decline in the Fed RRP reflects that, following the resolution of the debt ceiling standoff in mid-2023, the Treasury stepped up T-Bill issuance. This lifted money market rates relative to the Fed RRP. As a result, liquidity migrated from the Fed RRP into other assets (Charts 3 and 4).

With uncertainties such as these, the Fed is taking no chances. It is slowing QT before reserves start falling and has announced it is monitoring several indicators of reserves scarcity.

Fed to Keep Reserves Ample

Based on reserves and bank assets alone, reserves would still be more than ample. As mentioned above, reserves are roughly unchanged relative to the start of QT – well above re-pandemic levels. At the same time, banks’ asset growth has been limited, which reflects limited demand for credit as well as competition from non-bank financial institutions.

As a result, reserves relative to banks assets are still well above pre-pandemic and well above the 12.5% threshold below which the FFR/IOER spread rose, a sign of tightening liquidity, in 2018-19 (Charts 6 and 7).

The Fed has announced it would be monitoring a series of indicators. These include elasticity of the FFR to reserves changes, FF borrowings by domestic banks, share of payments settled after 5pm, intraday overdraft, and share of RP trades above IOR (Chart 8).

Assuming bank assets and the RRP remain flattish, and an asset run rate of $35bn/month, it could take another 3-4 quarters before reserves become ample.

That said, uncertainty exists over demand for reserves. Several academics and analysts have argued bank demand for reserves increases with supply and may be unstable.

From a market perspective, I am not sure it matters that much. The Fed clearly intends to accommodate the demand for reserves, whatever it may be. It slowed QT even though reserves have not fallen yet!

In addition, the link between the quantity of reserves and asset performance is tenuous. The June 2023 scare over the impact of the increase in the TGA on equities turned out to be unfounded, possibly because the TGA build up was funded through T-Bill issuance. This put pressure on money market rates and therefore led to more of a decline in the RRP than in reserves. Longer term, it is difficult to see a strong relationship between reserves and equities (Chart 9).

Market Consequences

The Fed is so intent on keeping reserves ample that an inadvertent shortage of liquidity seems unlikely. Therefore QT, is unlikely to have much market impact.

I still expect one 2024 insurance cut at the November or December FOMC meetings. By contrast, markets are pricing 2.5 cuts by December and a 98% probability of a cut in September.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)