Fed Slows Treasury Runoff to $25B, Aims for Market Stability

Key Takeaway

• The Fed is slowing its balance-sheet reduction to $25 billion monthly for Treasuries, maintaining liquidity and evaluating market conditions.
• Despite a $1.5 trillion reduction, the optimal level of bank reserves remains uncertain, prompting a cautious approach to further cuts.
• Market stability indicators like fed funds vs. IORB spread and federal funds borrowing suggest reserves are still ample despite quantitative tightening.

Fed's Prudent QT Adjustment

The Federal Reserve's recent decision to slow the pace of its balance sheet reduction, a move detailed by the Federal Reserve Bank of New York's Roberto Perli, marks a significant shift in the central bank's approach to quantitative tightening (QT). Since beginning the QT process nearly two years ago, the Fed has reduced its balance sheet by over $1.5 trillion, bringing it down to $7.4 trillion. The decision to lower the monthly cap on maturing Treasuries from $60 billion to $25 billion, while maintaining the cap for mortgage-backed securities at $35 billion, is aimed at giving policymakers more time to assess market conditions and ensure liquidity within the banking system.

Perli emphasized that this adjustment is a cautious step towards determining the optimal level of bank reserves necessary for the smooth functioning of money markets. This approach is expected to maintain market stability with a lower reserve supply than if the runoff had continued at its previous pace.

Market Stability Amid QT

Despite the significant reduction in the Fed's balance sheet, key indicators suggest that the financial system remains resilient. The effective fed funds rate has been stable, and the repurchase agreement market has only experienced occasional funding pressures. This stability is partly attributed to the reverse repo facility (RRP), which has absorbed much of the balance sheet runoff. However, as the RRP's usage declines or stabilizes, bank reserves will decrease in tandem with the portfolio unwind, necessitating careful monitoring by the Fed.

Perli highlighted several metrics being watched by policymakers, including the spread between fed funds and interest on reserve balances (IORB), the total federal funds borrowing by domestic banks, and patterns in outgoing interbank payments and daylight overdrafts. These indicators will help determine when reserves reach an ample level, ensuring that the banking system has sufficient liquidity to support daily operations and payment activities.

Kashkari and Powell on Monetary Policy

In related news, Fed officials, including Neel Kashkari, have signaled a cautious stance on the future direction of Treasury yields and monetary policy. Amidst the backdrop of an election year and ongoing debates about rate cuts, Fed Chair Jerome Powell faces a delicate balance in navigating the central bank's policy decisions. The adjustments to QT and the careful monitoring of market conditions reflect the Fed's broader dilemma of supporting economic growth while managing inflation and ensuring financial stability.

Street Views

• Roberto Perli, Federal Reserve Bank of New York (Neutral on the US banking system's liquidity and market conditions):

  "While implementation will not look much different, slowing runoff nonetheless represents an important and prudent step in the balance sheet reduction process... Ultimately, I expect that this approach will allow money markets to continue to function smoothly with a lower level of reserve supply than would have been the case had runoff been allowed to proceed at its current pace for much longer."