Late last year, the Federal Reserve ended its latest quantitative tightening (QT) program: the process by which it shrinks its balance sheet by selling securities or letting them mature without reinvestment. From a peak size of almost $9 trillion, or roughly 35% of U.S. GDP, the Fed had reduced the balance sheet by more than $2 trillion. Unlike in 2019, when a spike in money market volatility prompted the Fed to abruptly halt QT, markets barely seemed to notice this time.
The lack of reaction is important. As then-Fed Chair Janet Yellen phrased it in 2017, QT is meant to run quietly in the background, “like watching paint dry.” By that standard, the uneventful conclusion to this latest QT round looks like a success.
So why then are some Fed officials – Governor Stephen Miran and other Fed staff – along with Fed Chair nominee Kevin Warsh (see our recent article) and several academics and former Fed staff (including Bill Nelson of the Bank Policy Institute) all advocating for further reduction? Many argue that the interaction between post crisis bank regulations and normal growth in banking deposits is likely to lead to an ever-larger Fed balance sheet unless policies are pursued to mitigate bank demand for reserves.
There are ways this can be achieved, and, indeed, the groundwork is already being laid to potentially restart a gradual process of QT as soon as later next year, in our view. If implemented in a gradual and predictable way, similar to past programs, with constant monitoring of large bank demands, we think the implications for broader markets will also be similar to the recent experience – negligible.
Demand for Fed liabilities drives the balance sheet
The size of the Fed’s balance sheet ultimately reflects demand for its liabilities. As with any institution, the Fed balance sheet is made up of assets and liabilities. The asset side is mainly U.S. Treasuries and agency mortgage-backed securities. The liability side includes cash in circulation, bank reserves kept at the Fed, and the Treasury’s general account.
Since the GFC, the Fed has relied on balance sheet expansion to mitigate the limits of the effective lower bound on interest rates and provide further monetary accommodation. It has funded those asset purchases by issuing reserve liabilities to banks. The extent to which the Fed is able to normalize its balance sheet in better times depends on banks’ demand for reserves and also on the public’s demand for currency.
Post-crisis regulations increased reserve demand by requiring banks to hold certain levels of high-quality, liquid assets (e.g., reserves) to back a portion of their funding –of which and large portion is deposits. Because the business of banking is making loans and issuing lines of credit, which create deposits, banks’ demand for reserves has continued to gradually grow over time as bank deposits have also grown. This has led to a larger Fed balance sheet while the ratio of central bank liquidity to bank deposits has fluctuated within a stable range as the Fed has expanded and contracted its assets for monetary policy reasons (see Figure 1).
Figure 1: Ratio of bank reserves to deposits has fluctuated but remained in range
Reducing the Fed balance sheet
Given the link between bank reserves and deposits, the Fed’s balance sheet is likely to keep gradually expanding over time, even in the absence of asset-purchase programs (quantitative easing, or QE). Some observers worry that if more isn’t done to reduce bank demand for reserves, then the ever-larger Fed asset holdings of Treasuries needed to accommodate bank demand for reserves could distort market pricing – including in repo funding markets for Treasuries – and reduce Treasury market liquidity. In addition to the Fed’s traditional responsibilities of being the lender of last resort, the Fed’s ever-growing size within the Treasury market could increase the need for the Fed to be market-maker of last resort in times of stress, which leads to questions of moral hazard. Various officials and academics have also shared concerns that an ever-expanding Fed balance sheet could blur the distinction between monetary and fiscal policy, which could threaten central bank independence.
These concerns underpin recent research,1 authored by Miran with other Fed economists, that aims to reduce bank demand for reserves despite higher deposits. Their research quantifies the menu of possible strategies, that, if implemented, could reduce reserve demand by an additional $1 trillion – $2 trillion over time. These aggregate numbers overstate what is likely and feasible within with next year or two; however, there is a subset of strategies that could be implemented more quickly freeing up closer to $500 billion in reserves, in our view.
Making structural changes to how banks settle daily payments through the Fedwire Funds Service to reduce banks’ need for liquidity buffers would likely take a few years to effectively implement – the Fed’s latest 24-hour Fedwire services has been available for just under three years with limited usage.2 Other proposals would require reforms to the Treasury’s general account management (which is out of the Fed’s control). Still others require changes in the way the Fed implements monetary policy and would have market trade-offs such as somewhat greater money market volatility and would require active daily reserve management operations.
Other strategies that require changes to the way the Fed implements large-bank liquidity rules could have a tangible impact sooner. Specifically, the Fed could change its large-bank liquidity, resolution, and stress test requirements to allow banks to assume usage of the Fed’s discount window in severe stress scenarios. The Fed could also encourage banks to shift current reserve holdings to other high quality, liquid assets (e.g., T-bills and short-dated agency securities), which could be pledged to the Fed as collateral for additional cash during periods of market stress. If the Fed encouraged banks to assume the use of these facilities, it could have the added benefit of destigmatizing their use.
As the rules are currently implemented, the Fed requires banks to hold enough liquidity to survive GFC-like episodes without assuming usage of Fed liquidity facilities. While that increases the safety and soundness of the overall banking system by reducing the need for the Fed to act as a backstop in period of high stress, it has come at the cost of a large Fed balance sheet in normal times – a state some have described as overkill.
Strategies to relax and more efficiently implement large-bank liquidity regulations have already been put in motion by Fed Governor Michelle Bowman, the vice chair for supervision. We believe regulators could propose changes to liquidity rules as soon as later this year and could take effect as early as January or April of next year.
Monitoring and managing the impact
The Fed appears to be on its way to implementing policies that seek to reduce banks’ demand for reserves. But how will the Fed monitor whether (and how much) bank reserve demand is actually falling? One sign would be small declines in money market rate spreads relative to the interest rate on reserve balances (IORB) paid by the Fed.
In the years since the Fed’s post-GFC balance sheet expansion, secured and unsecured overnight money market rates have tended to trade 5 to 10 basis points below IORB (see Figure 2). As the Fed drained reserves, those rates traded more in line with IORB, or even slightly above. As these rates drift down again, that should signal that the strategies are working. However, even if money market rates ease, there is still a question of how much bank demand for reserves is falling. To get a better gauge, Fed bank regulators would need to continually survey large banks on their minimum comfortable levels.
In order to restart quantitative easing, we think the Fed would, at a minimum, need to be relatively sure that bank demand for reserves has fallen by at least $500 billion, something that we think appears feasible in light of Miran’s study.
Figure 2: Money market spreads have tended to shift along with bank reserves
What does this mean for broader markets?
Potentially not much, if implemented gradually and with continued monitoring. Large banks will still be required to hold a portion of their assets in highly liquid securities. However, giving them more flexibility outside of reserve holdings would likely mean that reserve holdings would shift into Treasury securities. Banks would seek to maximize returns within the new framework, and now that the Treasury yield curve is upward-sloping, banks have the incentive to swap reserves for higher-yielding, liquid Treasury securities. Various academic models linking Treasury supply to the term premium that investors require to hold those securities suggest limited impact on yields. Treasury could also shift issuance toward short-dated maturities to limit the market impact.
Overall, this suggests that shifting bank holdings of reserves could be uneventfully absorbed by markets – like watching paint dry.
Del Anderson and J. R. Scott contributed to this article.
