Fed eyes slowing balance sheet runoff as liquidity concerns emerge

The US Federal Reserve is poised to slow the shedding of some its trillions in asset holdings and may soon stop altogether over concerns that the runoff will dent liquidity in bond markets.

Central bankers are shedding about $100 billion per month from the Fed's holdings, yet liquidity concerns are mounting. Nearly $2 trillion has flowed out of a Fed facility designed for stability in lending markets. The Fed has managed to shrink its balance sheet by $1.278 trillion since peaking at nearly $9 trillion in April 2022, when the Fed launched its battle against skyrocketing inflation.

Those concerns have drawn fresh questions for the Fed — how soon will the central bank stop shedding holdings, how large the balance sheet will remain once that process ends and how will it impact bond markets — as the process of reducing the balance sheet has come into greater focus.

"It's moving up the to-do list for the Fed," said Kathy Jones, managing director and chief fixed-income strategist with the Schwab Center for Financial Research.

Building up, running down

As part of its policy response to the COVID-19 pandemic, the Fed cut short-term interest rates to zero in March 2020 and then began nearly two years of monthly purchases of $80 billion of Treasurys and $40 billion of agency mortgage-backed securities. The Fed's balance sheet ballooned to $8.965 trillion in April 2022 from $4.174 trillion at the start of 2020, as the bond purchases ceased and the central bank began reducing its balance sheet as part of a policy of quantitative tightening (QT).

The Fed has been reducing the balance sheet by nearly $100 billion in Treasurys and mortgage securities each month, bringing it down to below $7.687 trillion as of Jan. 10. The Fed is letting these bonds mature without reinvesting the funds in their respective markets, effectively increasing the supply of bonds and pushing yields higher as prices fall. These higher yields are raising related borrowing costs and taking the place of additional increases to the Fed's benchmark interest rate.

Fed officials discussed the balance sheet at their December 2023 meeting, noting that it would expect to "slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level judged consistent with ample reserves," according to the meeting's minutes.

Yet, how the Fed will judge when reserves are "ample" is still unclear.

The central bank's balance sheet remains about 85% higher than it was before the pandemic and could be reduced significantly more as the Fed continues its QT policy push. But the question of when the balance sheet runoff begins to slow and finally ends, as well as the potential size Fed officials want it to be, will largely depend on liquidity.

"Liquidity problems in the banking system or Treasury market could cause the Fed to begin tapering QT sooner, and the lack of any noticeable issues could lead them to keep the current pace for longer," said Lyn Alden, an independent investment research provider.

One key gauge of liquidity in the financial system is the Fed's overnight reverse repurchase facility, which was permanently established in 2014 as a way to stabilize lending and remove excess cash from the financial system. The facility allows certain banks, money market funds and other investment firms to earn interest on large cash balances kept at the Fed overnight.

The facility surged to a record $2.554 trillion in December 2022 but has since fallen to $583 billion, its lowest level since June 2021.

Given the "rapid decline" of the facility, Fed officials needed to begin discussions of slowing the runoff of the central bank's balance sheet, Federal Reserve Bank of Dallas President Lorie Logan said in a Jan. 6 speech.

"In my view, we should slow the pace of runoff as [facility] balances approach a low level," Logan said.

Ample reserves

As long as the repurchase facility is being used, there are likely ample reserves in the financial system, said Althea Spinozzi, a senior fixed-income strategist with Saxo Bank. Even if the facility drops to zero, it does not mean reserves are scarce.

Reserve balances with Federal Reserve banks, for example, climbed to nearly $3.499 trillion on Jan. 10, up from $2.830 trillion a year earlier.

How the Fed judges the state of liquidity in the financial system will likely dictate when it will begin to slow its balance sheet reduction. While slowing the reduction of the balance sheet could boost liquidity, the Fed may prefer to keep selling off holdings in anticipation of future situations where a significant policy shift may be needed.

"I am sure the Fed would want to have a leaner balance sheet in order to put it in use for another crisis," Spinozzi said. "It's impossible to say whether the Fed would be able to unwind it to levels seen pre-COVID."

It is unclear if Fed Chairman Jerome Powell will address tapering the balance sheet at the Fed's next meeting at the end of January and will likely make no commitment since nearly $600 billion remains in the reverse repo facility. There have also been no signs of liquidity stress for months, said Alden.

Still, the Fed's balance sheet will likely never return to where it was before COVID-19, Alden said.

"The total amount of deposits and assets in the banking system are notably higher than they were pre-pandemic, and a correspondingly higher amount of base money is therefore also likely to persist so that banks don't have liquidity problems," Alden said.

"Attempts by the Fed to bring the balance sheet to that level will likely result in disorderly actions in the bond market and give them a firm signal to stop."