What the Fed will do
The Fed's next moves. Analysis by Tom Hollenberg, Capital Group Bond Portfolio Manager
The Fed has signaled that rate cuts are coming, although it has not said when they might occur, leaving its benchmark interest rate unchanged in a range between 5.25% and 5 .50% for the fifth consecutive meeting. Fed Chair Jerome Powell also addressed the central bank's quantitative tightening (QT) programs, saying it will soon begin to slow (or reduce) the pace at which it is reducing its balance sheet, but provided no details on the possible start of tapering.
Since June 2022, the Fed has been conducting a round of quantitative tightening, slowly reducing the size of its balance sheet by allowing securities to mature and not reinvesting the related proceeds. Now that inflation is approaching the Fed's target, the central bank has signaled that it will taper quantitative tightening, meaning the balance sheet will continue to shrink, but at a slower pace. According to recent statements by members of the Fed's Board of Governors, the most realistic scenario appears to be one in which the central bank begins tapering the QT program in June, assuming that the Fed believes there will be a sufficient level of liquidity in the market. liquid assets. Powell said slowing the pace of QT does not mean the Fed is changing the final target level of its balance sheet, although tapering means approaching that target “more gradually.”
It remains to be seen what the impact on markets will be, but the slowing run-off should reduce the likelihood of an unwanted liquidity crisis occurring in US Treasury markets and, by extension, risk assets in general.
So far the QT effects have been subdued
Rates have risen and the Fed's balance sheet has contracted, but to date the effects of QT appear subdued as labor markets have remained resilient and economic growth has continued to expand. One reason is that the Fed's decreased use of overnight reverse repo (RRP) operations, where eligible investors, such as banks or money market funds, can invest cash without risk, has helped counter balance sheet operations of the Fed.
When investors access the RRP, the invested sums are not used within the banking system. This is essentially "dead money". Therefore, the accumulation of RRPs recorded in 2021 and 2022 basically served as a further form of monetary tightening. Then, in 2023, the RRP started to shrink and had the opposite effect. Even with the QT underway, bank reserve balances remained above USD 3 trillion and actually grew as the RRP ran out. If the RRP draw approaches USD 500 billion, the QT will start to take its toll.
A QT slowdown could benefit the markets and act as a protection against a new crisis
The relationship between fiscal policy and financial conditions is not necessarily linear. Apparently, members of the Federal Open Market Committee (FOMC) fear that if reserves get too low, it could put the financial system in trouble. The Fed does not want to see another crash or episode of market volatility, as happened in 2019. Aside from the minor banking crisis of early 2023 – related more to the inverted yield curve than QT and which was quickly contained – today on the market the problems related to financing appear to be very limited. Bank reserves held at the Fed have doubled since 2019, i.e. the last QT tapering. In late 2023, however, short-term bank lending rates spiked enough to suggest the United States may not have “abundant reserves” within the banking system. Additionally, in January, Dallas Fed President Lorie Logan – widely considered one of the Fed's most prominent voices on this issue – gave a speech arguing that the central bank could begin planning for a QT slowdown as soon as the of the RRP will have reached a more contained level.
We believe the Fed is not just looking at aggregate levels of funding within the system, but is also concerned with ensuring that market participants have broad access to liquidity. If, for example, 90% of banks have ample liquidity, but 10% have difficulty accessing financing, this is still a problem. As observed for Silicon Valley Bank, it only takes a few operators in difficulty to create problems for everyone else too.
QT may continue for a long period of time
It remains to be seen how long QT will continue. At the current rate (with a maximum ceiling of USD 95 billion per month, after having reached only around USD 75 billion), it may take another year of quantitative tightening before reaching the "reassuring minimum level of reserves" estimated by the members of the Board of Fed Governors. It is important to note that establishing the “reassuring minimum level of reserves” is not an exact science, but recent Fed projections suggest that there may be approximately USD 600 billion of excess reserves still to be reduced. Once QT tapering occurs, the Fed may need even more time to reach its goal.
The Fed's “put option” is back
The QT tapering could also serve the Fed to signal to the markets the direction taken by policy. If the Fed begins to reduce its balance sheet more slowly, the market is likely to expect the next step to be an end to QT. Looking ahead, it could also indicate that the next time a downturn occurs, markets can expect the balance sheet to begin expanding again. Overall, I think it will be very difficult for the balance sheet to return to the significantly low levels of the pre-2020 period. Fed Governor Christopher Waller has been very transparent about this. He spoke about how managing a large budget is a public good, as he believes it helps implement monetary policy. I believe many of your colleagues share this view.
In our view, the Fed intends to completely liquidate its MBS holdings to achieve an all-Treasury portfolio. However, when the next recession hits, it will be difficult to avoid purchasing them again, as the housing market is a key part of the economy. Aside from the surge in inflation, which could be attributed to factors such as fiscal policy and supply chain issues, as well as measures taken by the Fed, the central bank could argue that the downside of its fiscal policy has been limited. In our view, if the balance sheet approaches USD 7 trillion, the Fed will likely be reassured. I imagine they would argue that their role is not so much maintaining the budget as maintaining price stability and full employment, and that the budget is helping them achieve those goals.
It therefore seems unlikely that the Fed's so-called “put option” (the expectation that the Fed would step in to support markets in the event of trouble) will disappear. Yet, there are always political tail risk scenarios to watch out for. In the late 1970s, for example, the Federal Reserve Act was amended to include full employment among the Fed's mandates. If the exact opposite were done and the Fed was instructed to focus solely on price stability or adopt rules-based monetary policy while ignoring the balance sheet, markets could be caught off guard. I don't think this is likely, but never say never.
In conclusion, the fact that the Federal Reserve is already talking about slowing the pace of quantitative tightening can help prevent a repeat of the liquidity crisis experienced by markets during the last QT cycle. Even if the QT will last longer, at a slower pace, the fact that Fed officials are willing to change course is to be considered a positive.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/fed-prossime-mosse-analisi-fed/ on Sun, 14 Apr 2024 06:16:05 +0000.