Five years later, the Fed’s balance sheet dynamics remain heavy

(Bloomberg) — As the Federal Reserve continues to shrink its balance sheet, it still has the same problems it faced more than five years ago.

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As market dynamics evolve, the key issue facing policymakers and investors is how to gauge liquidity in the financial system and avoid the disruptions that forced the Fed to intervene in September 2019, with the Fed depleting its holdings.

The central bank has reduced its assets by more than $2 trillion since the start of the process known as quantitative tightening in mid-2022. Now, a large number of Wall Street strategists expect the Fed to end the QT period in the first half of the year, given the levels in its re-easing facilities. Reverse buying, a measure of excess liquidity that has become almost empty, and other factors such as bank reserves. They also point out that the recent turmoil in the repo market, most notably at the end of September, was not a result of Fed actions as was the case in 2019.

“Some things may have changed since then, most notably that the Treasury market is much larger and issuance is very high,” said Stephen Zeng, a strategist at Deutsche Bank. Restrictions on traders’ ability to mediate the market were also a greater contributor to repo volatility than the scarcity of reserves, which could be a key difference.

Back in 2019, a combination of factors, including a scarcity of reserves as a result of the QT – combined with the payment of large corporate taxes and the settlement of a Treasury bond auction – led to a liquidity crunch, sending key lending rates skyrocketing and forcing the Fed to intervene. To achieve economic stability. market.

So far it remains unclear where the point of reserve scarcity lies, although officials have said it is a comfortable minimum level for banks as well as a reserve buffer. Balances currently stand at $3.33 trillion, a level that officials consider abundant, and it is about $25 billion less than the level they were at when the dismantling process began more than two and a half years ago.

For some market participants, the lack of decline indicates that the ideal level of institutional reserves is much higher than expected, and that some banks are actually paying higher funding costs in order to hold cash. Results of the Federal Reserve’s latest chief financial officers survey released last month showed that more than a third of respondents are taking steps to maintain current levels.

The debate over adequate reserves and the QT breakpoint is not new. At the January 2019 meeting, then-Fed Governor Lael Brainard cautioned against looking for the steep bank-reserve portion of the demand curve, warning that it would “necessarily lead to rises in money price volatility” and “there will be a need for… new to contain it. “

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