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Markets more confident Fed balance sheet drawdown has room to run

Updated: 06-11-2024, 11.44 AM

By Michael S. Derby

NEW YORK (Reuters) – Financial markets are heading into this week’s Federal Reserve meeting with more clarity over the outlook for the U.S. central bank’s ongoing balance sheet drawdown than they’ve had in a while, and those keeping close tabs on the process see it continuing into next year even as the Fed keeps cutting interest rates.

The clarity is largely tied to a new index from the New York Fed that charts pressures in short-term market liquidity. Called Reserve Demand Elasticity, it appears to front-run liquidity shortages, and in its first outing showed money markets still flush with cash. That in turn means the Fed faces no serious roadblocks to continue with the now two-year-old process of shedding bonds from its balance sheet, which is known as quantitative tightening, or QT.

“Runoff will last into (the first quarter) and perhaps even beyond, we believe, judging by the NY Fed’s new real-time Reserve Demand Elasticity measure,” analysts at LH Meyer said in a research note late last month. A New York Fed survey ahead of the September policy meeting saw QT ending in the spring of next year.

The New York Fed index and its findings go to the heart of one of the key components of the Fed’s monetary policy regime, which is to extract unneeded liquidity it had added to markets during the COVID pandemic and its aftermath.

The Fed aggressively bought Treasury and mortgage bonds starting in March 2020, first to stabilize markets and then to add stimulus when its main monetary policy tool, the federal funds target rate, was at near-zero levels.

Those purchases more than doubled the Fed’s balance sheet to a peak of about $9 trillion by the summer of 2022. That same year the Fed began to allow bonds it owned to mature and not be replaced, and it has shed about $2 trillion of those securities so far. In that recent NY Fed survey, markets reckoned Fed holdings would contract to around $6.4 trillion.

The Fed is aiming to pull out enough liquidity to enable it to retain firm control over the federal funds rate and to allow for normal periods of money market volatility. The challenge is that there is no clear way to know how far to take QT.

Fed Governor Christopher Waller said on Oct. 14 “there is no economic theory for how large a central bank balance sheet should be.” In terms of when QT might end, New York Fed President John Williams on Oct. 10 said “I don’t actually know, because it depends on what happens” with money market rates.

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