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Wednesday, June 7, 2023

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The Fed’s 2.5trn problem

Ccentral bank Make $2.5 trillion in cash disappear without anyone noticing? This is the impossible, if not audacious, task the Fed has embarked on, trying to shrink its massive balance sheet while minimizing disruption to the economy. This process – known as “quantitative tightening” (qt)—starting in mid-2022. The Fed has divested nearly $500 billion in assets, which is off to a good start. But recent ripples in the banking system portend turbulence to come.Some analysts and investors believe these pressures will eventually force the Fed to withdraw qt far ahead. Others doubt the central bank has the time and the tools.

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This sounds like a technical, arcane debate. It’s definitely complicated. But it also goes to the heart of modern monetary policy. Like other central banks, the Fed has come to rely on quantitative easing (qe) — large-scale asset purchases, especially government bonds — to stabilize financial markets and boost the economy during a deep recession.for qe For future work, qt Now it has to work: You can only expand your balance sheet in a bad economy if you shrink it in a good period, or the balance sheet will get higher and higher.

Since the 2007-9 global financial crisis, the Fed has taken qe Four times, resulting in a lot of research on how it works.In contrast, the Federal Reserve has adopted qt Only once, from late 2017 to 2019, was an early stop after currency markets started to crash. So there’s a lot of uncertainty about its consequences.

A Superficially Appealing Way of Thinking qt like qe on the contrary.like qe involves creating central bank reserves to buy bonds, so qt Involves removing reserves when the central bank cuts its holdings.like qe help keep long-term interest rates down, so qt raise them. Shrinking the Fed’s balance sheet by about $2.5 trillion over several years would have about the same impact as raising interest rates by half a percentage point, the researchers estimate.

Many believe this has already happened, with markets raising long-term interest rates as the Fed sets its policy. qt last year’s plan.Fed Governor Christopher Waller argues that the Fed is now simply meeting expectations as investors have already priced in the announced cuts: “The balance sheet is just running in the background.” Fed Official Says qt Should be as exciting as watching paint dry.

The problem with this analogy is that while the paint gets drier, qt become more treacherous.This is what distinguishes it from qe. When economic conditions are good, the central bank can gradually withdraw qe. in the case of qtHowever, the danger is that the Fed needs to experience market turmoil to realize that it has gone too far, as it did in 2019.initial qt Funding is being drawn from the liquid commercial banking system; however, as it continues, liquidity becomes tighter and banks’ funding costs could soar without much warning.

The past few weeks have previewed the possible stress. Some banks that have recently lost deposits have turned to the federal funds market, borrowing reserves from other lenders to meet regulatory requirements. Daily borrowing in the federal funds market averaged $106 billion in January, the highest figure since 2016. The tightening has so far been limited to smaller banks, a hopeful sign that the financial system is returning to its pre-pandemic state, with big banks lending to their weaker peers. However, this raises the question of whether and when other banks will run into shortfalls.

Views on the Fed’s liabilities support the view that tightening is far off. About $3 trillion is bank reserves (actually central bank deposits). Another $2 trillion is money from companies that swap Treasuries with the Fed (such as overnight reverse repurchase agreements, or reverse repurchase agreements, that allow them to earn a small return on excess cash).mr waller once said qt Should run smoothly until bank reserves reach around 10% gross domestic product, at which point the Fed will slow down the reduction of its balance sheet in an attempt to find the right size for the financial system. If reserves and reverse repos are interchangeable, as Mr Waller suggests, then reserves are now equivalent to 19% gross domestic product, leaving enough space.therefore qt It could go on for a few more years, slashing the Fed’s balance sheet in the process.

But problems may arise before that. First, banks may need more reserves than they did pre-covid-19 because their assets are expanding faster than in other economies. Second, and crucially, reverse repos and reserves may not actually be interchangeable. Much of the demand for reverse repos has come from money market funds, which are an alternative to bank deposits for companies looking for slightly higher returns. If this need persists, qt Instead, more reliance will be placed on bank reserves. Strategists at investment firm T. Rowe Price believe that under such circumstances, reserves could be depleted by the end of the year. The Fed’s balance sheet will be stuck at around $8 trillion, almost double its pre-pandemic level.This will exacerbate concerns about its ability to start qe in the future.

Oddly enough, the debt-ceiling chaos likely overshadowed any debate in the coming months. Since the Treasury cannot borrow until Congress raises the debt ceiling, it is reducing its cash holdings at the Federal Reserve. As money leaves the Treasury’s accounts, much of it ends up in the banking system, which in turn helps banks replenish reserves.

But when Congress does move to raise the US debt ceiling, the Treasury will need to borrow more. For banks, this could mean a rapid drain on reserves. The Fed has created a lending facility to ease this tightening. However, it’s unclear how well it will perform in the wild, adding even more uncertainty to the development process. qt. Markets may be calm for now. It’s unlikely to stay that way.

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