Mar 1, 2024 - Economy

How the Fed can avoid a 2019 balance sheet repeat

Data: Federal Reserve; Chart: Axios Visuals
Data: Federal Reserve; Chart: Axios Visuals

Federal Reserve interest rate decisions get plenty of attention. But the central bank will soon consider a big change to its other major monetary policy tool as it aims to avoid the type of financial chaos sparked the last time it tried to shrink its multitrillion-dollar balance sheet.

Why it matters: The Fed will decide when to wind down its process of withdrawing cash from the financial system — quantitative tightening, the reverse of quantitative easing.

  • The huge debate is how to do so, and when to stop — with memories of 2019's serious market disruptions haunting officials.

Where it stands: Since 2022, the Fed has allowed some $1.4 trillion in bonds purchased as a pandemic stimulus measure to roll off its balance sheet.

  • Fed chair Jerome Powell told reporters in January that officials will begin "in-depth discussions of balance sheet issues" — including when it could slow it down — at its next policy meeting, later this month.

Flashback: When the Fed last shrank its balance sheet, the process ended somewhat abruptly after it caused wild dysfunction in the money market.

  • QT had been underway for more than a year when the Fed said it would pull back, with the aim of ending the reduction in late 2019.
  • But around that time, it was clear the process had resulted in too much money — or reserves — being sucked from the banking system. The result was a sharp jump in short-term borrowing rates that wreaked havoc in a key part of the world's financial plumbing.
  • The turbulence caused such panic that the Fed ultimately reversed course and resumed expanding the balance sheet.

The intrigue: Top Fed officials want to avoid a 2019 redux, but it's tricky. Policymakers don't know how much reserves can decline before it potentially sparks trouble in funding markets.

  • "The money market stress in September 2019 revealed the threshold was much higher than previously thought," Fitch Ratings chief economist Brian Coulton wrote in a recent note, noting that there are few concerns "reserves are close to that threshold now."
  • Back then, the Fed's balance sheet was below $4 trillion. Now, it is $7.6 trillion.

What they're saying: "The challenge today is knowing how far to go in normalizing the balance sheet," Dallas Fed president Lorie Logan said Friday morning at a conference in New York hosted by the Clark Center for Global Markets at the University of Chicago.

  • "If reserves drop too far, we would fall out of the floor system and see substantial upward pressure on money market rates," Logan said. "There's more upside rate risk from reserves falling too low than downside rate risk from reserves rising too high."

The big picture: New York Fed president John Williams told Axios last week that the central bank will embark on a two-step process in considering changes to its balance sheet.

  • First, officials will decide when to begin tapering the runoff. The second part is ending the reduction at a point "above that which we thought was consistent with ample reserves," Williams said.

Wall Street analysts will try to game out what this "floor" is for reserves — but the exact level is unknown, a fact Logan acknowledged.

  • "I know that everyone is really hoping I'll go one step further and say what level of reserves corresponds to the ample level," Logan said. "I'm going to disappoint you. Banks' demand for reserves varies significantly over time as the economy and financial system evolve."

Top policymakers appear to agree that moving more gradually could help avoid the type of disruption seen five years ago.

  • "Learning from our experiences and trying to understand how the demand for reserves has changed over time suggests moving carefully toward the endpoint" of quantitative tightening, Fed governor Christopher Waller said at the same conference Friday morning.

What to watch: Fed officials note the central bank's standing facility could allow banks to borrow cash from the central bank for a short period could help smooth over any turmoil. Five years ago, that backstop didn't exist.

  • "[O]ne of the lessons from that experience, I think from all discussions with market participants watching what happened — having that facility, I think, would have provided more assurance in markets that rates would not continue to spike and stay high," said Williams last week.

Yes, but: At least one official has warned that the supersized Fed balance sheet creates distortions in the financial system, and the central bank should not be reluctant to shrink it out of fear of disrupting money markets.

  • Jeff Schmid, president of the Kansas City Fed, said this week that "once a crisis has passed, it should be a priority for the Fed to reduce its balance sheet and to lessen its footprint in financial markets."

The bottom line: The Fed will likely move delicately to avoid a 2019 repeat.

  • "We're being, I would say, prudent and careful in not pushing too hard on the level of reserves to such a low level that it can create market volatility or disruption of the kind we saw before," Williams said.
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