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(Bloomberg) — As the Federal Reserve continues to unwind its balance sheet, it is still dogged by the same problems it was more than five years ago.
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While market dynamics have evolved, the main issue facing policymakers and investors is how to gauge the liquidity of the financial system and avoid the turmoil that forced the Fed to intervene in September 2019, as the Fed exhausts its holdings.
The central bank has reduced its assets by more than $2 trillion since the process known as quantitative tightening began in mid-2022. Now, a plurality of Wall Street strategists expect the Fed to end QT during the first half of the year, given the levels of the reverse repo line, a measure of excess liquidity, being near empty and other factors such as bank reserves. They also point out that the recent turmoil in the repurchase agreement market, particularly in late September, was not the result of Fed actions as it might have been in 2019.
“Some things may have changed since then, mainly the Treasury market is much bigger and issuance is very high,” said Deutsche Bank strategist Steven Zeng. Limitations on dealers being able to broker the market have also contributed more to repo volatility than a shortage of reserves, which could be a key difference.
In 2019, a confluence of factors, including a shortage of reserves as a result of QT, combined with a large corporate tax payment and a liquidation of Treasury auctions, led to a liquidity crunch, causing key lending rates would soar and force the Fed to intervene to stabilize the market.
Even now it remains unclear where that reserve shortfall is, although officials have said it is the lowest comfortable level for banks plus a buffer. Balances currently stand at $3.33 trillion, a level officials consider ample, and about $25 billion below where they were when the easing began more than two and a half years ago.
For some market participants, the lack of decline has suggested that the ideal level of reserves for institutions is much higher than expected and some banks are actually paying higher funding costs to hold cash. Results from the Fed’s latest survey of senior financial officers released last month showed that more than a third of respondents were taking steps to maintain current levels.
The debate about appropriate reserves and QT stopping point is nothing new. At the January 2019 meeting, Fed Governor Lael Brainard cautioned against seeking the steep side of the bank reserve demand curve, warning that it “would necessarily involve spikes in funds rate volatility” and that “new tools would be needed to contain it”. “
