Fed Balance sheet run-off will likely end in second half of 2024
The FOMC has started to reduce the size of its balance sheet in June 2022 to complement the rate hiking cycle that had started two months earlier. Its primary objective was to remove excess liquidity from the system and to help tighten financial conditions. To this end, the Fed is currently reducing the amount of fixed income securities it holds by 95bn USD/month through not fully reinvesting redemptions in its securities portfolio.
A quick look at a simplified Fed balance sheet will clarify the underlying dynamics. The securities held outright on the asset side of the Fed’s balance sheet mainly consist of US Treasury and mortgage backed securities acquired via various asset purchase programmes. Any reduction in securities held by the Fed implies that the private sector needs to step up. That could be a bank or a private sector investor, but in either case, the reduction in the Fed’s securities portfolio will destroy bank reserves and deposits.
The impact from QT on bank reserves is not always immediately visible. Two important items on the Fed balance sheet liability side are important: (1) The Treasury General Account (TGA), which is essentially the checking account of the government at the Federal Reserve, and (2) the Overnight Reverse Repo Facility (O/N RRP), where a wide range of market participants (e.g. money market funds) can deposit short-term funds with the Fed. Changes in the TGA account or the O/N RRP are effectuated through the banking system and can induce an (opposite) change in bank reserves.
The Overnight Reverse Repo Facility (O/N RRP) usage started to surge from March 2021 as the restoration of the Supplementary Liquidity Ratio (SLR) made banks less willing to accept deposits. This drove investors, with few alternatives, to move cash from low yielding bank deposits into money market funds instead of parking the money at the O/N RRP. This caused bank reserves to fall sharply before Quantitative Tightening could even be started. O/N RRP usage started to fall significantly after the resolution of the debt-ceiling crisis at the beginning of June 2023. Indeed, the resolution allowed the US Treasury to replenish its Treasury General Account (TGA), thus increasing the availability of higher-yielding Treasury Bills to money market funds. The recently relatively calm US banking sector has led more money market funds to turn to higher yielding alternatives such as the repo market. This sharp drop in ON/RRP has absorbed much of the effect of QT on bank reserves in 2023.
It is also notable that the US banking system has fought against a reduction of its reserve balances this year. After the regional banking crisis in particular, banks have increased their cash buffers and opted to replace deposit outflows with a sharp increase in expensive large term-deposits, thus keeping reserves up. Banks have become much more cautious and are keen to build up liquidity buffers to insure against renewed stress in the financial system.
The Fed estimates that the minimum level of required bank reserves is likely around 8% of GDP, which is a bit higher than the reserve levels in September 2019 when the USD funding crisis broke out. Currently, reserve levels are about 11% of GDP, but given the banking system’s strong preference for liquidity, the optimal reserves are probably not far below current levels. There is roughly 950bn USD of O/N RRP outstanding. If outflows continue at around the current pace, it would be close to zero during H2 2024, at which point the Fed would likely need to end QT to prevent issues in USD funding markets.
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