(Bloomberg) — As the Federal Reserve continues to unwind its balance sheet, it’s still dogged by the same issues that it faced more than five years ago.
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While market dynamics have evolved, the main issue facing policymakers and investors is how to measure liquidity in the financial system and avoid turmoil that forced the Fed to intervene in September 2019, as the Fed runs down it holdings.
The central bank has reduced its assets by more than $2 trillion since the process known as quantitative tightening began in mid-2022. Now, a plurality of Wall Street strategists expect the Fed to end QT in the first half of the year, given levels at the reverse repo facility, a measure of excess liquidity, being nearly empty and other factors like bank reserves. They also note recent turbulence in the market for repurchase agreements, most notably at the end of September, was not the result of Fed actions as it may have been in 2019.
“Some things may have changed since then, notably the Treasury market is much larger and issuance is very elevated,” said Deutsche Bank strategist Steven Zeng. Constraints on dealers being able to intermediate in the market has also been “a bigger contributor to repo volatility than reserve scarcity, which could be a key difference.
Back in 2019, a confluence of factors, including reserve scarcity as a result of QT — combined with a large corporate tax payment and Treasury auction settlement — led to a liquidity crunch, sending key lending rates skyrocketing and forcing the Fed to intervene to stabilize the market.
Even now it’s still unclear where that point of reserve scarcity lies, though officials have said it’s banks’ lowest comfortable level plus a buffer. Balances are currently $3.33 trillion, a level officials consider to be abundant, and roughly $25 billion below where they were when the unwind started more than two-and-a-half years ago.
To some market participants, the lack of decline has suggested the ideal level of reserves for institutions is much higher than expected and some banks are actually paying higher funding costs in order to hold onto cash. The results of the Fed’s latest Senior Financial Officer survey released last month showed more than one-third of respondents were taking steps to maintain current levels.
The debate over adequate reserves and QT’s stopping point is nothing new. At the January 2019 meeting, then-Fed Governor Lael Brainard cautioned against looking for bank reserves’ steep part of the demand curve, warning that it would “necessarily entail spikes in funds rate volatility” and “new tools would be needed to contain that.”
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Brainard at a later meeting also noted the risk that the end of the Fed’s QT could coincide with swings in reserves associated with the approach of the debt ceiling, adding that the level could be very different from normal balances.
Fast forward, and concern over the debt limit muddying the outlook for reserves resurfaced. In the minutes of the latest Dec. 17-18 gathering, System Open Market Account manager Roberto Perli noted “the possibility that the potential reinstatement of the debt limit in 2025 could result in substantial shifts in Federal Reserve liabilities that could pose challenges in assessing reserve conditions.”
One notable evolution since the 2019 discussions is the establishment of a Standing Repo Facility, which was introduced in July 2021. The SRF is used by eligible banks and primary dealers to borrow funds overnight in exchange for Treasury and agency debt thereby a source of liquidity. By providing financing at rates set by the Fed, the goal is to ensure the federal funds rate doesn’t move outside the central bank’s policy target range.
Back at the June 2019 meeting, Chair Jerome Powell saw two potential attractions to the SRF: avoiding spikes in the fed funds rate and keeping bank reserves as small as possible.
Yet the facility remains infrequently used given that on Sept. 30 as quarter-end bank activity pushed funding rates higher, balances jumped to a mere $2.6 billion, which was the highest level since before the daily operations were made permanent. The Fed recently added a morning operation around the turn of the year to further support market participants.
A main critique of the facility is that it is not centrally cleared so any activity will add to balance-sheet costs. That circles back to constraints facing dealers and their ability to intermediate in the market.
“The 2019 discussions should inform their thinking around the SRF today to some degree,” Detusche Bank’s Zeng said. Back then “they viewed too much and too frequent take-up at the SRF as an adverse outcome, and they worried about risk of moral hazard as with all liquidity backstop facilities.”
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