Federal Reserve’s Balance Sheet Strategy

By Michael S. Derby
NEW YORK (Reuters) – The Federal Reserve’s efforts to reduce its balance sheet are entering a phase of uncertainty, as key excess liquidity indicators are nearly depleted.

In recent days, cash inflow into the central bank’s overnight reverse repo facility has dwindled to nearly zero, following a gradual decline from a peak of $2.6 trillion at the end of 2022. This facility primarily accepts cash from money market funds, allowing them to manage their excess liquid assets. The decline in reverse repos began when the Fed initiated its balance sheet reduction in 2022, through a process known as quantitative tightening (QT), which has reduced its holdings from a peak of $9 trillion in the summer of 2022 to around $6.7 trillion now.

The interest rate the Fed offers for these loans is crucial for its monetary policy, helping to determine the central bank’s interest rate target, currently between 4.25% and 4.50%. As of Thursday, reverse repos were at $32 billion, a level last observed in spring 2021. Despite the anticipated decline, some analysts expect temporary spikes in usage around month and quarter-ends when liquidity changes affect funding needs.

Time of Testing

QT is expected to continue for some time, with market participants suggesting it could last until early next year. Although reverse repos have effectively dried up, Fed officials believe considerable liquidity persists within the banking system that QT can further reduce.

The significant reduction in reverse repo usage will test this assumption. With Treasury borrowing resolved after the Republican spending bill, QT will now remove reserves more rapidly from the banking system. Currently, banking system reserves are approximately $3.3 trillion, a steady figure over recent years. Observers are uncertain how far these can decline before liquidity constraints trigger significant market volatility that might disrupt the Fed’s interest rate management. This scenario recalls the previous QT phase which ended in September 2019, when excessive liquidity withdrawal led to erratic short-term rates and the Fed was compelled to inject temporary liquidity into markets to stabilize the system.

The Fed is attempting to avoid a repeat of that situation with its newly introduced Standing Repo Facility (SRF), which facilitates quick cash in exchange for bonds. The SRF has seen limited usage at quarter-ends when liquidity tightens, but the Fed anticipates greater reliance on it moving forward. At its July meeting, a New York Fed official indicated to the Federal Open Market Committee that reserves might briefly dip below standard levels during critical financial timelines, but that the SRF would likely support orderly money market operations.

Nevertheless, the SRF remains untested in high-demand scenarios, posing risks about its efficacy as a buffer. The Fed is prepared to conduct traditional repo operations if extra liquidity is necessary.

The current situation involves numerous complexities, leading many Fed analysts to express uncertainty about future developments. Fed Governor Christopher Waller hinted earlier this summer that reserves might eventually settle around $2.7 trillion. However, some market participants believe QT may soon need to cease.

Scott Skyrm of Curvature Securities remarked, “Something changed in markets. Massive bill issuance flooded the market with new Treasury supply, the reverse repo facility is nearing zero, and bank reserves are declining,” accompanied by increased funding pressure in the repo market. He suggests that QT should be halted this fall considering the tightening monetary conditions.