NEW YORK (Reuters) – Financial markets are looking ahead to this week’s Federal Reserve meeting with more clarity on the U.S. central bank’s ongoing balance sheet unwinding than they have in a long time, and those watching the process are seeing it. continue until next year as the Fed continues to cut interest rates.
Clarity has a lot to do with a new index from the New York Fed that charts the short-term money market. Called the Reserve Demand Elasticity, it appears to be lacking in the past, and in its first outing it showed money markets are still flush with cash. That means the Fed has no serious obstacles to continuing the now two-year process of shedding bonds from its balance sheet, known as quantitative tightening, or QT.
“The runoff will last (the first quarter) and possibly beyond, we believe, judging by the NY Fed’s new Reserve Demand Elasticity estimate,” LH Meyer analysts said in a research note late last month. The New York Fed survey ahead of the September policy meeting saw the QT ending in the spring of next year.
The New York Fed’s index and its findings go to the heart of one of the most important parts of the Fed’s monetary policy regime, which is to remove the unnecessary money it has added to the markets during the COVID crisis and its aftermath.
The Fed aggressively bought Treasury and mortgage bonds starting in March 2020, first to stabilize markets and then add momentum when its main monetary policy tool, the federal target rate, was near zero.
Those purchases more than doubled the Fed’s balance sheet to a peak of $9 billion by the summer of 2022. That same year the Fed began allowing the bonds it held to mature and not be replaced, and it has liquidated nearly $2 billion of those securities. until now. In that latest NY Fed survey, the markets calculated that Fed Holdings would contract for about $6.4 trillion.
The Fed aims to issue enough money to be able to maintain tight control over the federal funds rate and to allow for normal periods of financial market volatility. The challenge is that there is no clear way to know how far you can take QT.
Fed Governor Christopher Waller said on October 14 that “there is no economic theory for how large a central bank’s balance sheet should be.” Regarding when QT might end, New York Fed President John Williams on October 10 said “I don’t really know, because it depends on what happens” with money market rates.
FRICTION IS OUT
The start of the Fed’s rate cuts in September has led some observers to speculate that QT needs to end soon to better align the two planks of monetary policy. At the same time, the turmoil in the currency market at the end of September, as the third quarter ended, showed unexpected strong conditions in other currency markets, which some saw as a reason to close QT immediately.
But that quarter’s negative turn didn’t faze Fed officials. “Currently, liquidity appears to be excessive,” said Dallas Fed President Lorie Logan, former chief executive of the New York Fed, on October 21. She added that rising pressures on calendar-based money markets “seem to indicate a temporary, arbitrage conflict.” instead of shortfall in providing the specified amount.”
The most notable for the Fed is the level of acceptance of its reverse repo facility, and how the rate of money supply remains in line with the levels determined by the Federal Open Market Committee, which meets on Wednesday and Thursday. in a circle that is almost certain to yield a quarter-percentage-point estimate.
The reverse repo facility is widely viewed as a proxy for excess liquidity, and has fallen from a peak of $2.6 trillion at the end of 2022 to $144.2 billion on Tuesday, the lowest level since early May 2021. Most Fed officials expect it to end. close to zero, and from that point on QT will start eating into more stable bank reserves. Until now, the fed funds rate has traded where the central bank wants. These two factors have combined to strengthen the confidence of policy makers that there is enough money left to move forward with QT.
With repos falling to record lows, market participants say the day the Fed will need to pull the plug is near. “QT is likely to be the headline” at the two-day policy meeting ending Thursday given the state of financial markets, Morgan Stanley analysts said.
They noted that the end of the year, which is usually a period of high financial market volatility, could be heralded as a result of the Treasury’s massive debt repayments. Morgan Stanley sees QT ending in the first quarter of next year. It also expects that if the reverse repo facility approaches zero, it will be a “hard ride” for the market, and added that an increase in the Secured Overnight Financing Rate will cover or exceed the Fed’s interest rate on the reserve balance, or IORB. , will show that there is enough money to complete the QT.
At the end of QT, other variables also appear. Officials such as Logan view the relationship of the standards as the common bond standard of the third party related to the IORB. The former rate was lower than the latter, and Logan views money market rates as a category that over time will need to exceed the interest rate on the reserve balance.
Another factor that may indicate the need to close the QT is the frequent, large use of the Standing Repo Facility, which provides quick cash in exchange with the Treasury to eligible financial firms. That tool got its first real-world test at the end of September, and if it survives, it could indicate liquidity problems that require a change in QT.
(Reporting by Michael S. Derby; Editing by Paul Simao)
