Federal Reserve officials are getting closer to identifying when they will end their market-sensitive balance sheet reduction programme, with some signalling it could be completed this year as they opt to keep a hefty quantity of reserves in the financial system.
Recent comments from policymakers, including Fed governor Lael Brainard and Philadelphia Fed president Pat Harker, point in the direction of well over $1tn of commercial bank reserves being maintained, said analysts.
Even if the Fed decides when to halt the programme, however, it still leaves open major questions over the future composition of the Fed asset holdings — an issue that could have important market ramifications of its own.
“The picture coming together is one of a central bank that wants to give the market as much of a concrete timetable in March as it can,” said Lou Crandall, chief economist at Wrightson Icap. “We don’t know the precise level of specificity they will achieve.”
The Fed swelled its balance sheet to $4.5tn as it battled the financial crisis and economic downturn, purchasing treasuries and mortgage-backed securities in a bid to buoy markets and the economy. Former Fed chair Janet Yellen put the process into reverse in 2017, gradually allowing the asset holdings to shrink as the central bank withdraws its monetary support for the economy.
Late last year investors developed an acute aversion to the Fed’s programme of reducing its asset holdings, arguing it was damaging equity markets. While Fed officials were sceptical about the complaints, Fed chairman Jay Powell sought to quell some of Wall Street’s angst last month by insisting the central bank was willing to change tack if financial or economic conditions required it.
The flipside of the Fed’s asset holdings are liabilities including currency in circulation and commercial bank reserves held on deposit with the Fed. The central bank has decided it wants to keep these deposits in more ample supply than before the crisis, but gauging the exact levels of reserves it needs to limit volatility in money markets is difficult.
Reserves are now about $1.6tn, down 40 per cent from their peak levels but far above pre-crisis norms. The Fed launched a survey of senior financial officers this month as it narrows down its options for the future quantity of reserves, on top of a survey it conducted last autumn. Mr Harker said in an interview with MNI this month that reserves would need to be $1tn to $1.3tn to prevent excessive volatility in money markets, plus a buffer to cover fluctuations in demand and supply.
Ms Brainard last week told CNBC that she wanted to see a “comfortable buffer” of spare reserves, with the balance sheet normalisation process coming to an end “later this year”.
Loretta Mester, the president of the Cleveland Fed, said the Fed would be finalising its plans for ending the runoff of its balance sheet at “coming meetings”, adding that the central bank had already made “considerable progress” in normalising the size of the balance sheet.
Analysts are looking for the Fed to indicate a range for the quantity of reserves in the system, as well as indications of an end-date for the reduction programme. Mr Powell said last month he wanted to approach the final level “quite carefully”, which some take to imply the Fed will slow, or taper, the speed at which its balance sheet shrinks as it glides towards an end point. The run-off is currently running at a pace of about $40bn a month.
But it is not just the eventual size of the balance sheet that investors are monitoring: the composition of its asset portfolio also matters. Currently, the Fed owns Treasuries ranging from two to 30 years, the standard maturity denominations, seeking to broadly reflect the make-up of the market. It does not buy shorter-dated Treasury “bills” in its asset portfolio.
After the balance sheet reduction process is over the Fed is expected to continue letting its holdings of mortgage-backed securities run off — and one looming question is whether it actively sells some of those MBS to clean them off its balance sheet more quickly. To maintain its balance sheet it will eventually have to become a net buyer of Treasury securities again. Some Fed policymakers want to weight new purchases towards shorter-dated securities, while others want to match the overall spectrum in the treasury market.
Orienting the Fed’s portfolio towards the shorter-dated securities could put downward pressure on shorter-dated yields and push longer-dated yields higher, in effect tightening financial conditions for companies borrowing money for longer periods of time. The benefit of this would be that should the economy fall into recession, the Fed will be in a position to reverse its tactic, buying more longer-dated Treasuries to help prop up markets as it did in the aftermath of the last financial crisis through what became known as “operation twist”.
Having a shorter-dated portfolio would also reduce interest rate risk and make it easier for the Fed to offset any massive future liquidity operations by letting assets quickly run off, some analysts say. But the market could take the decision over the future portfolio composition as an indication about the Fed’s economic outlook: if the bank chooses to buy lots of short-dated securities investors may take it as a sign of a more hawkish stance.
“Given the focus on a potential recession it is one of the policy levers that could be pulled to signal a more or less accommodative stance of policy,” said Jon Hill, an interest rate analyst at BMO Capital Markets.
Complicating the picture is the Treasury department’s resulting issuance strategy as it responds to future Fed portfolio decisions. Much as the Fed would like to play down the market sensitivity of its balance sheet strategy, it will remain of acute interest to Wall Street for a long time to come.
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