MNI: Forks In Road Ahead For Fed's QT Plan -Ex-Staff

Treasury market dysfunction or a recession next year will likely end the Federal Reserve's plan to unload trillions of dollars of government assets from its balance sheet, but a soft landing could see QT running another two years as planned, former Fed economists told MNI.

Having trimmed USD1.1 trillion from their nearly USD9 trillion assets held at peak last year, Fed officials are keen to continue normalizing the balance sheet as long as they're also holding interest rates high enough to restrain economic activity.

But market participants worry that banks' desire to hold more cash after sudden deposit outflows wiped out several regional lenders this year means reserve scarcity is closer at hand than the Fed believes and, when reached, will trigger sharp and unpredictable moves in markets akin to the repo crisis of 2019 that halted QT and prompted a Fed intervention.

At the same time, the recent sharp rise in Treasury yields -- if sustained -- could overly tighten financial conditions and help drag the economy into recession, in which case the Fed will also likely end QT.

"There's a very real risk of a repeat of September 2019, where the Fed suddenly found that the amount of reserve balances they'd supplied was less than market demand," said Johns Hopkins University economist Jonathan Wright, a former staff economist at the Fed Board of Governors. "If you wait until you have unmistakable evidence that you've shrunk the balance sheet too much, it'll be too late and we'll have a money market blow up."

SO FAR, SO GOOD

Post-Covid QT has so far gone smoothly, with the Fed's ample reserve operating framework performing "quite well" through a rapid rise in interest rates, high demand for precautionary liquidity by banks and a sharp increase in debt issuance after a long debt ceiling negotiation, New York Fed's System Open Market Account manager Roberto Perli said earlier this month.

The New York Fed projects another USD1.5 trillion in balance sheet reduction through 2025. But Wright, along with rates strategists from Bank of America, UBS and JP Morgan at a recent Bank Policy Institute talk, reckon QT could end by mid-next year as cash becomes scarce.

The March regional bank turmoil and proposed higher capital requirements for big banks are likely to bump up lenders' lowest-comfortable cash holdings, while additional system liquidity in the form of USD1.5 trillion in cashed parked by money market funds in the Fed's overnight reverse repo facility may not be so easily redistributed, they said.

"The Fed should be actively thinking about how much further they want to go with this," Wright said.

RECESSION END

Fed officials however continue to maintain that RRP and reserve balances are substitutable. The pools combined are expected to shrink to around USD3.8 trillion by mid-2024, still much higher than the typical estimate of abundant reserves at around USD2.5 trillion, said former New York Fed SOMA trader Joseph Wang.

"Treasury market volatility and issues of market functioning would shift the debate in favor of those who would like to stop QT. But I’m not aware of any estimate that suggests significantly higher demand for reserves," Wang said. "Even if the estimate had moved higher, ending QT mid-next year would reflect a comically high estimate."

Fed officials have discussed allowing QT to run as they start to cut rates toward a neutral stance next year, meaning the bar for ending QT for macro reasons -- as opposed to financial stability reasons -- is high.

"My forecast is we get a mild recession. The Fed is cutting in the second half of next year. In that event I do see QT coming to an end," former New York Fed economist Matthew Raskin told MNI. "But I put decent odds on a soft landing. And in that case, QT keeps going."