Fed winding down balance sheet contraction amid tightening money markets

By Michael S. Derby

(Reuters) -The Federal Reserve on Wednesday said it is ending the drawdown of its still substantial balance sheet amid evidence money market liquidity conditions have begun tightening and bank reserve levels dropping.

Instead of allowing up to $5 billion in Treasury securities to mature each month and not be replaced, the Fed said that beginning December 1 it would now seek to hold steady its stock of government bonds by rolling over maturing Treasuries. The Fed also said it was maintaining its current plan to allow up to $35 billion in mortgage-backed securities to expire each month – a target it has never achieved in more than three years of reductions – but beginning December 1 will reinvest all proceeds from maturing MBS into Treasury bills.

The shift in the Fed’s balance sheet plans came in a meeting where the central bank’s Federal Open Market Committee trimmed the fed funds rate by a quarter percentage point, to between 3.75% and 4.00%.

“Our long-stated plan has been to stop balance sheet runoff when reserves are somewhat above the level we judge consistent with ample reserve conditions,” Federal Reserve Chair Jerome Powell said at a press conference following the FOMC gathering. “Signs have clearly emerged that we have reached that standard in money markets,” he added.

The Fed’s shift on QT was widely expected due to rising borrowing costs in the short-term lending markets the central bank seeks to influence as part of its work to achieve its job and inflation goals.

Over recent days the federal funds rate has been moving higher within its range as other key short-term lending rates have moved up. At the same time, the Fed’s Standing Repo Facility, which exists to provide fast cash loans on Treasuries, has sprung to life after several years of seeing almost no activity, recording its highest usage ever on Wednesday.

For Fed watchers, these developments indicated the Fed was effectively at the point where there is enough liquidity in the financial system to allow policymakers firm control over their interest rate target, while allowing for normal levels of volatility in money market rates.

That said, the end point has come quite a bit sooner than many had expected. In a survey done before the Fed’s September policy meeting, market participants eyed a first-quarter stopping date for QT, with Fed holdings at $6.2 trillion, versus the current level of $6.6 trillion.

The Fed has been mindful of not taking too much liquidity from the system as that could cause it to lose control of the fed funds rate, as it did briefly during the last iteration of QT six years ago. Central bankers have sought to avoid a replay of that event.

QT aimed to remove the huge wash of liquidity the Fed added to the financial markets during the COVID-19 pandemic. As part of an effort to support the economy, Fed holdings more than doubled from early 2020 levels to $9 trillion by the middle of 2022. QT has been steadily reducing Fed holdings since that peak. Most of QT to date has extinguished the excess of cash eligible firms had parked in the reverse repo facility, which has fallen from $2.6 trillion at the close of 2022 to seeing a near dearth of activity.

That said, in stopping now the Fed will move forward with a balance sheet that’s considerably larger than the $4.2 trillion level seen at the onset of the COVID-19 pandemic.

Since the conclusion of meaningful reverse repo usage, QT has been lowering reserve levels, although they still remain within a range that has held for a number of months.

TIME TO GROW

Over coming months, a number of analysts reckon the Fed will have to start rebuilding its holdings with new purchases of bonds, not as a form of stimulus but to keep financial system liquidity at the right levels in an expanding economy.

Powell noted that at some point in the not-too-distant future the Fed will need to grow holdings simply to keep holdings neutral in regard to “the size of the banking system and the size of the economy.”

Paul Ashworth, chief North America economist with research firm Capital Economics, said the Fed’s next step “will be to begin expanding the balance sheet by roughly $20 billion per month” to allow the financial system’s monetary base to match the expansion of gross domestic product.

At the same time, as the Fed looks toward the future, it will also have to think about how it wants its holdings to be positioned, given the central bank’s preference for all Treasury holdings more skewed to shorter-end securities than is currently the case. The Fed will also have to wrestle with the ongoing challenge of getting mortgage bonds off its books, which has been slow to happen given the current state of the housing market.

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(Reporting by Michael S. Derby; Editing by Andrea Ricci)