The Fed’s Liquidity Conundrum: Unwinding the Balance Sheet
As the Federal Reserve continues to shrink its balance sheet, it’s still grappling with the same liquidity issues that plagued it over five years ago. Despite market dynamics evolving, the central concern remains: how to measure liquidity in the financial system and avoid turmoil.
A $2 Trillion Reduction
The Fed has reduced its assets by more than $2 trillion since quantitative tightening began in mid-2022. Now, a majority of Wall Street strategists expect the Fed to end QT in the first half of the year, citing low levels at the reverse repo facility and other factors like bank reserves.
Repo Market Turbulence
Recent volatility in the repurchase agreement market, particularly at the end of September, was not caused by Fed actions, unlike in 2019. Deutsche Bank strategist Steven Zeng notes that constraints on dealers’ ability to intermediate in the market have contributed more to repo volatility than reserve scarcity.
The 2019 Liquidity Crunch
Back in 2019, a combination of factors, including reserve scarcity and a large corporate tax payment, led to a liquidity crunch, sending key lending rates skyrocketing and forcing the Fed to intervene. Even now, it’s unclear where the point of reserve scarcity lies, although officials consider current balances of $3.33 trillion to be abundant.
The Ideal Level of Reserves
Some market participants believe the ideal level of reserves for institutions is higher than expected, with banks paying higher funding costs to hold onto cash. The Fed’s latest Senior Financial Officer survey showed over a third of respondents taking steps to maintain current levels.
The Debate Over Adequate Reserves
The debate over adequate reserves and QT’s stopping point is ongoing. Former Fed Governor Lael Brainard warned against looking for bank reserves’ steep part of the demand curve, cautioning that it would lead to spikes in funds rate volatility.
The Debt Ceiling Concern
Concerns over the debt limit muddying the outlook for reserves have resurfaced. System Open Market Account manager Roberto Perli noted the possibility that the reinstatement of the debt limit in 2025 could result in substantial shifts in Federal Reserve liabilities.
The Standing Repo Facility
The establishment of a Standing Repo Facility in July 2021 has been a notable evolution since the 2019 discussions. The SRF provides financing at rates set by the Fed to ensure the federal funds rate doesn’t move outside the central bank’s policy target range.
Criticisms and Constraints
Critics argue that the facility is not centrally cleared, adding to balance-sheet costs. Constraints facing dealers and their ability to intermediate in the market remain a concern. Deutsche Bank’s Zeng notes that the 2019 discussions should inform the Fed’s thinking around the SRF today, considering the risk of moral hazard as with all liquidity backstop facilities.
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