(Bloomberg) -- Federal Reserve policymakers are gearing up for a bigger discussion about the central bank’s balance sheet, but for now it’s clear officials are keen to make it as small as possible. 

In the minutes of last month’s Federal Open Market Committee meeting, some participants said slowing the pace of the runoff — a process known as quantitative tightening, or QT — could help a transition to the point where bank reserves are considered ample and allow the FOMC to continue its balance sheet unwind for longer. Participants also judged that liquidity in the financial system remained “more than ample” and discussed the importance of assessing these conditions during the process. 

At the heart of the debate is how small the central bank can make its balance sheet — almost $9 trillion at one point — without causing financial markets dislocations or derailing its broader policy goals. So far it has shrunk by about $1.3 trillion since QT started in June 2022. 

Yet there’s still about $3.54 trillion of bank reserve balances — a large liability on the balance sheet, at a level that’s higher than when the central bank started its asset reduction in June 2022. The Fed’s overnight reverse repurchase agreement facility or RRP — where eligible counterparties can park cash to earn a market rate — has been draining to get to its current amount of $575 billion.

In recent months, Fed Chair Jerome Powell has said the current round of QT will end when reserves reach their lowest comfortable level, plus some sort of buffer. However, it remains unclear exactly what the optimal level of bank reserves is.

Some Wall Street strategists say that amount is higher than estimated amid post-crisis regulations and banks’ concerns about capital in the wake of last year’s regional bank turmoil. 

During last month’s press conference that followed the FOMC meeting, Powell said that policymakers are planning a more in-depth discussion of liquidity at the March meeting.

Heading to Zero

It “doesn’t sound like a committee that wants to end QT anytime soon even if the reverse repo facility heads towards zero but they should at least discuss,” Peter Boockvar, chief investment officer at Bleakley Financial Group, said in a note after the release of the minutes. 

QT has been in place for more than a year and a half, with the Fed letting as much as $60 billion in Treasuries and as much as $35 billion in agency debt holdings mature each month. But a debate has been simmering over whether the central bank is misjudging how much it can tighten liquidity without creating a scarcity of reserves in the financial system.

Wall Street strategists have been trying to determine whether the unwind can continue even after the RRP is empty and how far bank reserves can shrink before their scarcity disrupts the funding markets, as happened in September 2019. Both Barclays Plc and Bank of America Corp strategists have pushed back their timing for the beginning of any QT taper.

Read more: Envisioning the End of Fed’s Quantitative Tightening: QuickTake

The importance of RRP levels was noted by Dallas Fed President Lorie Logan, who said in January the central bank should slow its balance sheet runoff as reverse repo balances approach a low level. John Williams, her counterpart at the New York Fed, noted last month that bank reserves — a key metric used to guide the unwind — are little changed from the Fed’s pre-QT days.

However, Julie Ann Remache, deputy manager of the System Open Market Account at the New York Fed, said in a speech earlier this month the balance sheet is unlikely to return to levels last seen before the Covid-19 pandemic, noting that it still has to accommodate the long-term growth of the financial system. 

©2024 Bloomberg L.P.