MNI INTERVIEW: Reserve Scarcity Yet To Materialize - Fed Econ

The Federal Reserve has room to keep running down its balance sheet because signs of reserve scarcity have yet to materialize in money markets, but officials may still have to end quantitative tightening earlier due to liquidity constraints, St. Louis Fed senior economist Amalia Estenssoro told MNI.

"Balance sheet normalization processes as practiced today are complex because there are several moving parts. Deciding when to fade the policy is not trivial," she said in response to emailed questions.

Asked whether she's seeing any money-market pressures suggesting the lowest comfortable level of reserves is closer than previously thought: "Not at all at the moment."

Fed officials have said there is a high bar to adjust quantitative tightening but there will be reassessments of the optimal level of reserves. Banking regulations and desired liquidity could push up the level of reserves where constraints begin to force money-market rates higher.

"It’s difficult to say with any precision because...financial markets keep evolving. There are not set rules for the process," Estenssoro said. "Banks’ demand for reserves responds to business-driven or regulatory-driven liquidity constraints. But these demands are not static and vary as the financial system expands or regulation changes."

HIGHER TARGET?

The St. Louis Fed economist said in the last quantitative tightening from 2017 to 2019 there appeared to be a lower limit of about 7% of nominal GDP, at which point money market rates would spike. That would amount to about USD1.9 trillion of reserves at current GDP. Reserves have been fluctuating around USD3.2 trillion in recent months.

In the Fed’s most recent survey of senior financial officers, 78% of respondents reported their institution prefers to hold reserves above their lowest comfortable level (LCLOR) and 35% preferring to hold additional reserves of at least 50% above their LCLOR.

Thus, desired liquidity may be something closer to 10% to 12% of nominal GDP, or between USD2.7 trillion to USD3.3 trillion, with the current level of reserve balances already around the upper bound of the estimate, Estenssoro recently wrote in a St. Louis Fed note with coauthor Kevin Kliesen.

There is an additional risk that ON RRP balances remain sizable and bank reserves represent the majority of the contraction of Fed liabilities as QT continues, she said. In this case, regulatory banking constraints could start binding sooner than expected. The ON RRP has recently fallen to about USD1.6 trillion.

Treasury is targeting a USD650 billion end-of-September cash balance, implying continued heavy bill issuance.

"The issue is that balance sheet normalization can either occur through a reduction of ON RRP takeout or a reduction in bank reserves. The latter could trigger binding regulatory constraints that affect market functioning."