New York, NY – Banks in the financial system maintain reserves with the Federal Reserve, engaging in short-term lending and borrowing activities known as repurchase agreements, or repos. These transactions, often secured by U.S. Treasurys, play a vital role in meeting short-term funding needs and maximizing returns on excess cash, with the market size exceeding trillions of dollars daily.
Aside from determining the benchmark interest rate for bank reserves, the Federal Reserve wields influence over monetary policy through the repo market and adjustments to its balance sheet. Quantitative easing involves large-scale asset purchases to inject cash into the system, driving down borrowing costs. Conversely, quantitative tightening, or QT, involves unwinding these positions.
Since June 2022, the Federal Reserve has been reducing its balance sheet through QT, allowing monthly maturities of $60 billion in Treasuries and $35 billion in mortgage-backed securities without reinvesting the proceeds. This approach aims to withdraw liquidity from the financial system. Following discussions at the latest FOMC meeting in March, Fed Chair Powell indicated a potential slowdown in the balance sheet reduction in the coming months.
The Fed’s balance sheet has diminished from a peak of nearly $9 trillion in 2022, post the pandemic, to around $7.4 trillion as of last week. Additionally, the Fed operates an overnight reverse repurchase agreement (RRP) facility, extending transactions beyond banks to encompass money-market funds and government-sponsored enterprises like Fannie Mae.
The balance in the overnight RRP facility has been decreasing over the past year, injecting cash into the banking system at a faster rate than the QT process has been subtracting it. With the facility balance projected to near zero by the end of June, the reduction in reserves will primarily impact banks directly.
The Federal Reserve aims to maintain “ample” reserves within the banking system, with the precise definition of sufficiency subject to debate. Some estimates suggest that ample reserves should constitute around 10% of gross domestic product, a figure that has recently dipped to 12%. The challenge lies in gauging when reserves no longer qualify as ample, an issue encountered during a volatile period in 2019.
By moderating the pace of QT in 2024, the Federal Reserve hopes to mitigate the risk of financial market disruptions akin to the 2019 episode, where abrupt spikes in repo rates necessitated an expedited halt to balance sheet reduction efforts. Powell emphasized that this adjustment does not imply a deviation from the overall goal of shrinking the balance sheet, but rather a longer timeframe to achieve it.
Federal Reserve officials stress that decisions regarding QT are distinct from those concerning interest rates, urging investors to exercise “patience.” This cautious approach underscores the intricate interplay between balance sheet normalization and monetary policy, highlighting the importance of strategic foresight to avert systemic stress within the financial system.