By Jamie McGeever
ORLANDO, Florida (Reuters) – A key measure of excess liquidity in the financial system is evaporating rapidly. Once it disappears, further reduction of the Federal Reserve’s balance sheet – ‘quantitative tightening’ – could trigger a potentially worrying decline in bank reserves.
Federal Reserve Chair Jerome Powell has long insisted that the central bank’s balance sheet management runs in the background to, and has no bearing on, monetary policy. Few could argue with that. Since 2022, the Fed has shrunk its balance sheet by more than $2 trillion, as it has raised interest rates, held them steady, and begun to cut them.
But this twin-track approach may be put to the test now that excess liquidity in the banking system has almost completely dried up.
The Fed’s overnight reserve repo (RRP) facility has dropped to $78 billion, a fraction of the $2.55 trillion peak in December 2022. This may not seem like a cause for concern. Indeed, Fed Governor Christopher Waller, widely regarded as one of the most influential Fed policymakers, previously referred to RRP funds as “excess liquidity that financial market participants do not want.”
That may be true, but once there is no excess liquidity sloshing around the system, liquidity drained by QT will have to come from bank reserves, the cash banks keep on hand at the Fed that oils the wheels of interbank lending and underpins confidence in the financial system.
Reserves are still plentiful. Public comments by Powell and other Fed officials, and the New York Fed’s ‘Reserve Demand Elasticity’ reserves tracking tool, all show reserves remain “abundant,” still above the amorphous “ample” sweet spot that Fed officials target.
Bank reserves currently stand at $3.2 trillion. That’s more than double the $1.4 trillion that sparked the market turmoil in September 2019, when liquidity fears sparked by falling reserves caused overnight repo rates to shoot up. The Fed abruptly stopped its QT program and began expanding its balance sheet again.
A repeat of this mini-panic is unlikely, given the lessons learned and the array of tools at the Fed’s disposal. But if bank reserves start falling, balance sheet technicalities will inject risk and uncertainty into markets and potentially alter the path of monetary policy, no matter how cautious the Fed purports to be.
FLASHING AMBER
While reserves are “abundant” in nominal terms, they may be approaching more worrying levels as a share of GDP. When the interbank ructions occurred in 2019, reserves had decreased to 7% of nominal GDP from 16% five years earlier. Reserves have now slipped into the 10-11% range, which Waller has said would be a sign that the Fed should take its foot off the QT pedal.
“Then we’ll kind of feel our way around to see where we should stop,” Waller said in January 2023. A year ago he said that range would be “an approximate end point for draining reserves out of the system.”
We’re there now.
The Fed’s balance sheet has fallen to $6.87 trillion from a peak around $9 trillion. The consensus view among primary dealers at the New York Fed is that QT will end in June this year with the Fed’s balance sheet just under $6.4 trillion and bank reserves just over $3 trillion.
But with the RRP so low, it’s difficult to envisage the Fed’s balance sheet shrinking nearly $500 billion by June and bank reserves barely moving. Either QT ends earlier, or reserves fall below that 10-11% of GDP threshold.
The Fed may have to opt for the first option, as the latter could lead to volatility in money markets.
“When there is enough short-term money/liquidity in the system, short-term rates tend to be well behaved; when there isn’t, overnight rates are at risk of spiking,” Jordan Jackson at JP Morgan Asset Management wrote recently.
There are obviously many factors Fed officials consider when assessing market liquidity, such as conditions across repo markets, money market funds, and other bank funding channels.
But the level of bank reserves is a key one to watch. It’s not flashing red, but it might be flashing amber.
(The opinions expressed here are those of the author, a columnist for Reuters.)
(By Jamie McGeever; Editing by Andrea Ricci)
