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The New York Fed is projecting the Federal Reserve could stop the runoff of its still-outsized balance sheet – a process popularly known as quantitative tightening – next year.
The 2023 Open Markets Operations report comes after Fed policymakers started to discuss last month when it will slow the monthly pace of shrinking its asset portfolio, which the Fed has signaled would take place “fairly soon.” Balance-sheet reduction has been at a rate of as much as $95B per month, but a plan for the QT stopping point is being mulled over by officials in order to lower the risk of market stress.
“Participants generally favored reducing the monthly pace of runoff by roughly half from the recent overall pace,” according to the minutes of the last Federal Open Market Committee gathering on March 19-20. The Fed’s holding of Treasuries and mortgage-backed securities have retreated by about $1.5T since the start of the runoff in June 2022.
The NY Fed’s trading desk laid out two scenarios whereby QT could end. In a “higher reserve” environment, runoff could halt in early 2025, with the balance sheet winding down to ~$6.5T. Under the “lower reserves” scenario, QT could stop mid-2025 at a $6T portfolio. Reserves simply are funds that depository institutions park at the Fed. Banks are required to hold a certain amount of them to ensure they always have liquid assets available in case of significant deposit outflows.
If the Fed allows reserves to decrease excessively, there is a risk of sparking volatility in the overnight funding market akin to the dramatic spike in repo rates in September 2019 – when the Fed last attempted to shrink its balance sheet. Conversely, excessive reserves drain bank capital, suppress lending activity, and firmly establish the Fed’s extensive presence in the Treasury and repo market.
Nevertheless, “future financial and economic conditions and their impact on the demand for reserves and the balance sheet are highly uncertain,” the report said.
Do note that QT is the opposite of QE (quantitative easing), an asset swap between the Fed and banks whereby the Fed buys Treasury securities in exchange for bank reserves. When the pandemic hit the U.S. in March 2020, the Fed responded by purchasing outsized quantities of Treasury debt and mortgage-backed securities by injecting reserves into the banking system, thus expanding its balance sheet. In all, the Fed has three policy tools at its disposal: QT/QE, rate cuts/hikes and forward guidance (think dot plot).
The NY Fed’s report also estimated that the net income generated by the central bank’s bond holdings could stay negative through 2024, before returning to profitability in subsequent years. Unrealized losses on its bond portfolio last year stood at $948.4B, due to the higher cost of interest-bearing Fed liabilities, compared with $1.08T in 2022. The sum of the Fed’s interest expenses in 2023 exceeded its earnings by $114.3B (vs. net income of $58.8B in 2022), it said last month.
