By Wolf Richter for WOLF STREET.
Powell in his speech today discussed the Fed's balance sheet, including:
- When QT might end: "In coming months," he said in the speech; "We're not so far away now, but there's a ways to go," he said in the Q&A.
- How the balance sheet's composition might change: Shifting to short-term T-bills and getting rid of the MBS entirely, including by selling them.
- How doomsday would unfold if the Fed were forced to stop paying the banks interest on their reserve balances.
The Fed has been operating officially under the "ample reserves regime" since early 2020. Reserves represent liquidity that banks keep in their reserve accounts at the Fed to pay each other on a daily basis as part of the payments system; to have liquidity on hand to deal with large swings of liquidity as they occur; to earn risk-free interest; and boost their regulatory capital.
"Reserves" are a liability on the Fed's balance sheet (amounts it owes the banks). The Fed pays the banks interest on their reserve balances, at a rate that is one of the five policy rates the Fed set at the FOMC meetings. Reserves are key.
When QT might end:
"Our long-stated plan is to stop balance sheet runoff when reserves are somewhat above the level we judge consistent with ample reserve conditions," he said in his prepared remarks.
"We may approach that point in coming months," he said. But then in the Q&A, he put the "coming months" into perspective:
"We're not so far away now, but there's a ways to go."
Even after QT has ended, "reserve balances will continue to gradually decline as other Federal Reserve liabilities grow over time," he said.
When QT ends, total assets remain level, and so total liabilities remain level, but as the other liabilities increase based on external demand, reserves will shrink further.
As assets remain level, while the economy grows, total assets as percent of GDP would decline further, which is a soft form of QT. The ratio has already declined from nearly 36% in 2022 to 21.6% currently. The ratio would continue to decline after QT ends, but more slowly.
This also occurred from the end of 2014 through 2017 when total assets remained flat while the economy grew, and the ratio therefore declined. QT-1 was phased in at the very end of 2017 and ran through mid-2019, which accelerated the decline of the ratio.
Even before 2009, before QE, the Fed's assets grew roughly with the economy, which is the normal condition (my discussion of the Fed's assets).
The three other "Federal Reserve liabilities":
- Currency in circulation (paper dollars, currently $2.4 trillion), which are demand-based, about half held overseas.
- The government's checking account (Treasury General Account or TGA) currently about $800 billion.
- Reverse repurchase agreements, by which counterparties can deposit cash at the Fed. They come in two flavors:
- Overnight reverse repos (ON RRPs) with US counterparties, such as money market funds. After three years of QT, they're down to near-zero.
- Reverse repos with "Foreign official and international accounts," $350 billion, with which foreign central banks deposit their USD cash at the Fed.
"A little bit of tightening in money market conditions."
"Some signs have begun to emerge that liquidity conditions are gradually tightening, including a general firming of repo rates along with more noticeable but temporary pressures on selected dates," he said.
In the Q&A, he referred to it as a "little bit of tightening in money market conditions."
For example, some rate volatility has crept into the $3-trillion-a-day portion of the repo market that is tracked by the Secured Overnight Financing Rate (SOFR), especially around month-end, quarter-end, and tax-day periods, when large amounts of liquidity get moved around.
In the days leading up to September 15, as companies paid corporate estimated taxes, SOFR rose by about 12 basis points over a three-day period to 4.51% (and higher intraday) on September 15, before settling back down to 4.38% on September 17.
When the rate cut became effective on September 18, SOFR dropped by 24 basis points to 4.14%, but then rose again to 4.24% by September 30 amid month-end liquidity flows. On Friday, October 10, it was back at 4.15%.
Already a year ago, Dallas Fed president Lorie Logan said: "Such temporary rate pressures can be price signals that help market participants redistribute liquidity to the places where it's needed most. And from a policy perspective, I think it's important to tolerate normal, modest, temporary pressures of this type so we can get to an efficient balance sheet size."
And if these liquidity pressures start getting out of hand, and repo rates spike, banks can borrow at the Fed's new and improved Standing Repo Facility (SRF) and at the improved Discount Window at the Fed's policy rates and lend to the repo market risk-free at the spiked repo rates and profit from the spread.
This supply of cash to the repo market would cause repo rates to settle back down toward the Fed's policy rates, while earning banks a bundle.
Back in 2019, when the repo rates blew out, the Fed didn't have the SRF, and the Fed ended up directly entering the repo market. Powell referred to that in his discussion.
Changing the composition of the assets:
He re-iterated the coming shift to short-term Treasury bills for part of the portfolio, which has been discussed by other Fed governors and presidents before, and re-iterated that the Fed would be getting rid of its MBS entirely, and that it might sell them outright.
"Relative to the outstanding universe of Treasury securities, our portfolio is currently overweight longer-term securities and underweight shorter-term securities. The longer-run composition will be a topic of Committee discussion," he said, and so it will crop up in the minutes over the next few months.
"Transition to our desired composition will occur gradually and predictably, giving market participants time to adjust and minimizing the risk of market disruption," he said.
"Consistent with our longstanding guidance, we aim for a portfolio consisting primarily of Treasury securities over the longer run," he said. And he added in his footnote 21:
"As noted in the minutes of the May 2022 FOMC meeting, the Committee could, at some point, consider sales of agency MBS to accelerate progress toward a longer-run SOMA portfolio composed primarily of Treasury securities."
His doomsday scenario if the Fed cannot pay interest on reserves.
There has been some talk to prohibit the Fed from paying interest to the banks on their reserve balances. Powell is not a fan of that. So he outlined this doomsday scenario that would unfold if the Fed were forced to stop paying interest on their reserve balances. So for your amusement, in Powell's own words:
"If our ability to pay interest on reserves and other liabilities were eliminated, the Fed would lose control over rates. The stance of monetary policy would no longer be appropriately calibrated to economic conditions and would push the economy away from our employment and price stability goals."
"To restore rate control, large sales of securities over a short period of time would be needed to shrink our balance sheet and the quantity of reserves in the system."
"The volume and speed of these sales could strain Treasury market functioning and compromise financial stability. Market participants would need to absorb the sales of Treasury securities and agency MBS, which would put upward pressure on the entire yield curve, raising borrowing costs for the Treasury and the private sector. Even after that volatile and disruptive process, the banking system would be less resilient and more vulnerable to liquidity shocks," he said.
