The Fed could reduce its balance sheet again. This is what emerges from an analysis by Pimco, but this – assures Tiffany Wilding, economist at Pimco – will not have “particular repercussions on the markets”.
At the end of last year, the Federal Reserve – Pimco notes – concluded its latest quantitative tightening (QT) program: the process through which it reduces its balance sheet by selling securities or letting them mature without reinvesting them. From a peak of nearly $9 trillion, or about 35% of US GDP, the Fed had reduced its balance sheet by more than $2 trillion. “Unlike 2019, when a peak in money market volatility had pushed the Fed to abruptly interrupt the QT, this time – Wilding underlines – it almost seemed as if the markets didn’t notice. A significant absence of reactions”. As then-Fed Chair Janet Yellen stated in 2017, – the economist continues – “QT is designed to unfold silently in the background, ‘like watching paint dry’ (an expression similar to our “watching the grass grow” ed.). In this regard, the smooth conclusion of this latest QT cycle seems like a success”.
Need for further budget reduction?
“Why then,” asks Wilding, “do some Fed officials (governor Stephen Miran and other staff members) along with Fed presidential candidate Kevin Warsh and several academics and former Fed staff members (including Bill Nelson of the Bank Policy Institute) all support the need for further reduction?” Many argue – explains the economist – that the interaction between post-crisis banking regulations and the normal growth of bank deposits could lead to an increasingly large Fed balance sheet, unless policies are adopted to mitigate banks’ demand for reserves. But – Wilding continues – “in our opinion, there are several ways to achieve this objective and the foundations are already being laid to potentially restart a gradual QT process starting from the second half of next year. If implemented in a gradual and predictable way, similar to previous programmes, with constant monitoring of demand by the large banks, we believe that the repercussions on markets in general will be similar to those of recent experience: negligible”.
The demand for Fed liabilities determines the size of the balance sheet
The size of the Fed’s balance sheet ultimately reflects the demand for its liabilities. “As with any institution, the Fed’s balance sheet is made up of assets and liabilities,” the economist explains. of assets by issuing liabilities in the form of reserves to banks. The extent to which the Fed will be able to normalize its balance sheet in better economic times will depend on banks’ demand for reserves and also on the public’s demand for cash.” In this scenario – notes Wilding – “post-crisis regulations have increased the demand for reserves, requiring banks to hold certain levels of liquid and high-quality assets (for example, reserves) to cover a part of their financing, largely made up of deposits. Since banking activity consists of granting loans and issuing credit lines, operations that generate deposits, the demand for reserves by banks has continued to grow gradually over time, in step with the increase in bank deposits. This has led to a larger Fed balance sheet, while the ratio of central bank liquidity to bank deposits has fluctuated within a stable range as the Fed expanded and contracted its assets for monetary policy reasons.”
Reduction of the Fed balance sheet
Given the link between bank reserves and deposits, “it is likely – we read in the analysis – that the Fed’s balance sheet will continue to expand gradually over time, even in the absence of asset purchase programs (quantitative easing, or QE)”. Some observers fear that if nothing is done to reduce banks’ demand for reserves, the Fed’s growing portfolio of Treasuries held to meet that demand “may distort market prices – including those in Treasury repo markets – and reduce Treasury market liquidity.” In addition to the Fed’s traditional responsibilities as lender of last resort, its increasingly massive presence in the Treasury market – according to Wilding – “could increase the need for the Fed to act as a market maker of last resort in times of stress, which raises questions of moral hazard.” Several officials and academics have also expressed concern that an ever-expanding Fed balance sheet could blur the distinction between monetary policy and fiscal policy, threatening the central bank’s independence. Concern underlying a recent research, written by Miran together with other Fed economists, aimed at reducing the demand for reserves by banks despite the increase in deposits. The research quantifies a number of possible strategies that, if implemented, could reduce demand for reserves by an additional $1 trillion to $2 trillion over time. “These aggregate data – highlights the economist – overestimate what is probable and feasible within the next year or two; however, in our opinion, there is a subset of strategies that could be implemented more quickly, freeing up around $500 billion in reserves”.
The Fedwire Funds Service and other possible strategies
The effective implementation of structural changes to the ways in which banks settle daily payments through the Fedwire Funds Service, aimed at reducing the need for banks’ liquidity reserves, – explains the economist – “would probably take a few years: the extension of the 24-hour Fedwire service has been available for just under three years and its use is still limited. Other proposals would require reforms in the management of the Treasury’s general account (which is outside the control of the Fed)”. Still others – he continues – require “changes in the way the Fed implements monetary policy and would involve market trade-offs, such as slightly higher volatility in the money market, and would require active daily reserve management operations”. Other strategies that require changes to how the Fed enforces liquidity requirements for large banks could have a tangible impact sooner. “Specifically,” Wilding explains, “the Fed could modify the liquidity, resolution, and stress testing requirements of large banks to allow banks to use the Fed’s discount window in severe stress scenarios. The Fed could also encourage banks to move current reserves held into other high-quality liquid assets (for example, T-bills and short-dated agency securities), which could be pledged as collateral to the Fed to obtain additional liquidity during periods of market stress. If the Fed encouraged banks to use the to such instruments, this could have the additional positive effect of reducing the stigma associated with their use. Under the rules currently in place, the Fed requires banks to hold sufficient liquidity to overcome episodes similar to the global financial crisis without having to resort to Fed liquidity facilities. “Although this increases the safety and soundness of the entire banking system, reducing the need for the Fed to act as a safety net in times of severe stress, this – notes the report – leads to a sizable Fed balance sheet in normal times, a situation that some they defined as excessive.”
Fed Governor Michelle Bowman, vice president for supervision, has already launched a series of initiatives aimed at loosening and making more efficient the enforcement of liquidity rules of large banks. “We believe – says the economist – that the regulatory authorities could propose changes to the liquidity rules already by the end of the year, with entry into force expected no earlier than January or April next year”.
Impact monitoring and management
If the Fed seems intent on implementing policies aimed at reducing the demand for reserves by banks, the question concerns how to verify whether (and to what extent) the demand for bank reserves is actually decreasing. “One indicator – says Wilding – could be represented by slight declines in the spreads on money market rates compared to the interest rate on reserves (IORB) paid by the Fed”. In the years following the Fed’s balance sheet expansion following the global financial crisis, overnight money market rates, both secured and unsecured, have tended to hover between 5 and 10 basis points below the IORB. When the Fed reduced reserves, these rates – as explained in the Pimco analysis – became more aligned with the IORB, or even slightly exceeded it. “The fact that these rates are falling again – underlines the economist – should indicate that the strategies are working. However, even if money market rates were to fall, it remains to be seen how much banks’ demand for reserves is falling. To get a clearer picture, the Fed’s banking supervisors should conduct continuous surveys among large banks on their minimum comfort levels. In order to restart quantitative easing, we believe that the Fed should, at a minimum, be relatively certain that banks’ demand for reserves banks has decreased by at least 500 billion dollars, which we consider plausible in light of Miran’s study”.
What will be the impact on the markets?
“Changes in reserves held by banks could be absorbed by the markets without any particular repercussions, ‘like watching paint dry’” concludes Wilding, hypothesizing a negligible impact if implementation occurs gradually and with constant monitoring. “Large banks – explains the economist – will still be required to hold a portion of their assets in highly liquid securities. However, granting them greater flexibility outside of reserve requirements would likely result in a shift from such reserves towards Treasury securities. Banks would seek to maximize returns within the new regulatory framework and, now that the Treasury yield curve is rising, they have the incentive to exchange reserves for liquid, higher-yielding Treasury securities. Various academic models linking the supply of Treasury to the term premium required by investors to hold such securities suggests a limited impact on yields. Treasury could also steer issuance towards short-term maturities to limit the impact on the market.
