(Bloomberg) -- The Federal Reserve’s balance sheet may not have that much further to shrink.
An unexpected rise in overnight interest rates is pulling forward a key debate among U.S. central bankers over how much liquidity they should keep in the financial system. The outcome will determine the ultimate size of the balance sheet, which they are slowly winding down, with key implications for U.S. monetary policy.
One consequence was visible on Wednesday. The Fed raised the target range for its benchmark rate by a quarter point to 1.75 percent to 2 percent, but only increased the rate it pays banks on cash held with it overnight to 1.95 percent. The step was designed to keep the federal funds rate from rising above the target range. Previously, the Fed set the rate of interest on reserves at the top of the target range.
Shrinking the balance sheet effectively constitutes a form of policy tightening by putting upward pressure on long-term borrowing costs, just as expanding it via bond purchases during the financial crisis made financial conditions easier. Since beginning the shrinking process in October, the Fed has trimmed its bond portfolio by around $150 billion to $4.3 trillion, while remaining vague on how small it could become.
This reticence is partly because the Fed doesn’t know how much cash banks will want to hold at the central bank, which they need to do in order to satisfy post-crisis regulatory requirements.
Officials have said that, as they drain cash from the system by shrinking the balance sheet, a rise in the federal funds rate within their target range would be an important sign that liquidity is becoming scarce.
Now that the benchmark rate is rising, there is some skepticism. The increase appears to be mainly driven by another factor: the U.S. Treasury ramped up issuance of short-term U.S. government bills, which drove up yields on those and other competing assets, including in the overnight market.
‘Watching and Learning’
“We are looking carefully at that, and the truth is, we don’t know with any precision,” Fed Chairman Jerome Powell told reporters on Wednesday when asked about the increase. “Really, no one does. You can’t run experiments with one effect and not the other.”
“We’re just going to have to be watching and learning. And, frankly, we don’t have to know today," he added.
But many also see increasingly scarce cash balances as at least a partial explanation for the upward drift of the funds rate, and as a result, several analysts are pulling forward their estimates of when the balance sheet shrinkage will end.
Mark Cabana, a Bank of America rates strategist, said in a report published June 5 that Fed officials may stop draining liquidity from the system in late 2019 or early 2020, leaving $1 trillion of cash on bank balance sheets. That compares with an average of around $2.1 trillion held in reserves at the Fed so far this year.
Cabana, who from 2007 to 2015 worked in the New York Fed’s markets group responsible for managing the balance sheet, even sees a risk that the unwind ends this year.
One reason why people may have underestimated bank demand for cash to meet the new rules is that Fed supervisors have been quietly telling banks they need more of it, according to William Nelson, chief economist at The Clearing House Association, a banking industry group.
The requirement, known as the Liquidity Coverage Ratio, says banks must hold a certain percentage of their assets either in the form of cash deposited at the Fed or in U.S. Treasury securities, to ensure they have enough liquidity to deal with deposit outflows.
The Fed flooded the banking system with reserves as a byproduct of its crisis-era bond-buying programs, known as quantitative easing, to stimulate the economy. The money it paid investors to buy their bonds was deposited in banks, which the banks in turn hold as cash in reserve accounts at the Fed.
In theory, the unwind of the bond portfolio, which involves the reverse swap of assets between the Fed and investors, shouldn’t affect the total amount of Treasuries and reserves available to meet the requirement. The Fed destroys reserves by unwinding the portfolio, but releases an equivalent amount of Treasuries to the market in the process.
But if Fed supervisors are telling banks to prioritize reserves, that logic no longer applies. Nelson asked Randal Quarles, the Fed’s vice chairman for supervision, if this was the Fed’s new policy. Quarles, who was taking part in a May 4 conference at Stanford University, said he knew that message had been communicated and is “being rethought.”
If Fed officials do opt for a bigger balance sheet and decide to continue telling banks to prioritize cash over Treasuries, it may mean lower long-term interest rates, according to Seth Carpenter, the New York-based chief U.S. economist at UBS Securities.
“If reserves are scarce right now, and if the Fed does stop unwinding its balance sheet, the market is going to react to that, a lot,” said Carpenter, a former Fed economist. “Everyone anticipates a certain amount of extra Treasury supply coming to the market, and this would tell people, ‘Nope, it’s going to be less than you thought.”’
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