MNI POLICY: Fed Seeks Market Signals To End QT, Pause Possible
MNI (WASHINGTON) - The Federal Reserve plans to keep reducing its balance sheet until market signals show reserves are transitioning from abundant to ample levels, though it may slow or pause this process while Congress negotiates a deal to raise the debt limit.
Current market-based indicators show banking system reserves remain abundant, and point to no imminent pressure to end quantitative tightening, which has trimmed over USD2 trillion from the Fed's balance sheet in three years with little impact on the financial system. Fed Chair Jerome Powell noted earlier this month "we have a ways to go" before QT concludes.
Thus far, QT has largely drained liquidity from the overnight reverse repo facility instead of lowering bank reserves, which have remained at around USD 3.2 trillion since 2022. But steadily declining RRP usage and money market pressures at recent quarter-ends and year-ends suggest excess liquidity in the financial system is drying up.
Meanwhile, as the X-date — the day when Treasury can no longer meet financial obligations in full and on time, estimated to be between June and August — draws near, the market indicators on which the central bank relies are increasingly unlikely to provide a robust advance signal of reserve scarcity.
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That's because reserves are set to move sharply higher as Treasury spends down the USD800 billion held in its Treasury General Account after hitting the statutory debt limit last month. Softness in money markets closer to the X-date could also see a rebound in take-up at the RRP facility.
Those flows would likely quickly reverse when Treasury begins to issue debt to rebuild the TGA upon an agreement to lift or suspend the debt ceiling, potentially leaving the banking system with too few reserves.
Various FOMC officials in January said the Fed should consider pausing or slowing balance sheet runoff to avoid the risk of over-draining reserves, according to the minutes of the meeting.
Should money market pressures emerge after the debt limit is resolved, the Fed's standing repo facility is in place to provide cash to banks and keep a lid on repo rates, which are closely tied to the Fed's benchmark fed funds rate. The backstop has performed decently well with the exception of on Dec 26, when a substantial volume of tri-party repo transacted at rates above the facility's offering rate. (See MNI: Fed's Standing Repo Facility Tested By Market Rate Spike)
The New York Fed plans to conduct a small value exercise March 5 to test its capability to settle a standing repo facility operation in the morning on the Bank of New York tri-party repo platform. Currently the facility is structured as a daily afternoon auction though the vast majority of dealer transactions conclude by morning.