Commentary on Political Economy

Wednesday 10 April 2024

 

Fed Prepares Slower Pace of Runoff for $7.4 Trillion Portfolio ‘Fairly Soon’

Officials have been allowing up to $60 billion in Treasury securities to run off every month and up to $35 billion in mortgage-backed securities to mature every month. The process is designed to shrink the Fed’s balance sheet, which topped out at nearly $9 trillion two years ago. 

In theory, runoff can put upward pressure on interest rates because private investors must absorb the increased supply of debt that isn’t being rolled over by the Fed. Slowing the pace of runoff could ease that pressure.

Minutes from the Fed’s March 19-20 meeting indicated most officials favored plans to reduce the pace of runoff “by roughly half” of the current overall pace. Because high interest rates have kept mortgage bond runoff at a subdued level, officials would leave that part of their program unchanged and instead slow runoff by allowing fewer Treasury securities to mature every month, the minutes said.

“The vast majority of participants…judged that it would be prudent to begin slowing the pace of runoff fairly soon,” the minutes said. A few others said they preferred to continue with the existing program and wait for evidence that short-term money market rates were rising before adjusting the dials.

Five years ago, balance-sheet runoff sparked upheaval in overnight lending markets, forcing a messy U-turn. The current deliberations indicate most officials are determined not to do that again.

When the Fed buys a bond from a bank or a bank’s customer, it pays for it through the electronic equivalent of printing money: crediting the bank’s account at the Fed. As its bondholdings grew, so did this electronic cash, called reserves. When the Fed shrinks its holdings, it drains those reserve deposits.

A bank uses reserves to manage transactions between itself, its customers, other banks and the central bank. The Fed and private-sector forecasters thought banks had far more than needed for this. But in September 2019, a sharp, unexpected spike in a key overnight lending rate suggested reserves had dwindled to the point they were either too scarce or difficult to redistribute across the financial system. The Fed began buying Treasury bills to add reserves back to the system and avoid further instability.

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Policymakers are weighing a slower pace of runoff because the Fed is shrinking its Treasury holdings twice as fast as it did five years ago. Continuing to run at this rate raises the risk that the Fed drains reserves so quickly that money-market rates jump as banks struggle to redistribute a dwindling supply of reserves.

Officials said at last month’s meeting they favored an approach that allowed them to reduce more of those holdings if they slow the process down and give the financial system more time to adjust to lower levels of reserves.

They have been motivated to consider changes this spring because of signs that a cash surplus in money markets is diminishing. The Fed allows money-market firms and others to park extra cash that would otherwise end up in reserves in an overnight reverse repurchase facility. The facility has shrunk to around $440 billion in recent weeks from $2.3 trillion one year ago.

Once that facility is nearly drained of cash, forecasting demand for bank reserves could be more uncertain, raising the risk that the Fed goes too far.

Market participants say the Fed needs to manage runoff carefully because banks may need more reserves than it realizes. That is because of regulations that require banks to hold higher-quality assets to meet unexpected demands for cash. Moreover, for 15 years banks have had so much cash as a result of the Fed’s operations that the interbank market where banks lent reserves to each other has atrophied. Market participants and Fed officials are less confident reserves can quickly go from banks with extra to those in need.

“Overly rapid reductions in bank reserves could outpace money markets’ ability to redistribute reserves to the banks that need them most. That would risk pressures that could force us to stop balance sheet normalization prematurely,” said Dallas Fed President Lorie Logan last week. Logan’s views carry weight because she served as the senior New York Fed executive responsible for managing the Fed’s asset holdings five years ago.

Write to Nick Timiraos at Nick.Timiraos@wsj.com

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