On quantitative tightening, the Fed is overly cautious
The level of inflation continues to be persistently high. That is why the Federal Reserve has been gradually decreasing the size of its balance sheet as part of its monetary tightening strategy. Currently, the balance sheet still holds over $7 trillion in assets from its previous round of quantitative easing. So why has the Federal Reserve chosen to reduce the rate of quantitative tightening by $35 billion per month despite the persistently high inflation?
The decision to slow QT by the Federal Open Market Committee stems from a need to ensure that banks have sufficient reserve balances to meet their daily cash requirements. Every dollar of these deposits at the Fed must be supported by Fed assets, as per the necessary requirements. If the size of the Fed’s balance sheet is reduced excessively and rapidly, there is a potential for banks to hoard cash, leading to a significant increase in overnight interest rates and causing disruption in wholesale funding markets. This occurred in September 2019, amidst a prior round of quantitative tightening. This time, the Federal Reserve is taking a more cautious approach to reducing the size of its balance sheet.
This idea has some merit, but the Federal Reserve could be more decisive. There are evident indicators that the Fed can utilize to track the possibility of a liquidity crunch prior to its occurrence.
Every single day, banks rely on a payment system known as Fedwire to transfer over $4 trillion from their Fed deposit accounts to one another. Ensuring the seamless flow of these payments on a daily basis is vital for the efficiency of the financial system, as they encompass various essential functions such as payrolls, vendor payments, trade settlements, and more.
Large banks frequently withdraw more money from their Federal Reserve accounts each day than they initially had, leading them to heavily depend on incoming payments from other banks during the day. Even though banks have the ability to overdraft their Fed accounts during the day, there are numerous regulations and tests in place to discourage globally important banks from doing so. These measures were implemented following the financial crisis of 2008-09.
Based on our analysis of Fedwire data, a recent study conducted by myself, Adam Copeland, and Yilin Yang reveals an interesting pattern. It appears that when banks find themselves with insufficient reserve balances, they tend to delay their payments to the major dealer banks that engage in securities trading until later in the day. As a result, these dealer banks take measures to preserve cash by increasing the interest rates they offer to their customers on wholesale funding transactions, often with significant increases.
In September 17, 2019, reserve balances were at such a low level that the 10 largest dealer banks participating in the Treasury repo markets experienced an unprecedented delay of around 150 minutes in receiving the first half of their incoming payments. That day witnessed a significant surge in rates on Treasury repos, catching market participants off guard with its extraordinary deviation. As a response to this liquidity crunch, the Fed promptly provided extra reserve balances to the banking system. The funding market liquidity and intraday payment timing quickly returned to normal within a few days.
In the future, predicting the necessary size of the balance sheet to prevent another liquidity crunch will pose a challenge for the Fed. Significant shifts in the financial system and regulatory landscape impact the amount of reserve balances required by banks to effectively operate the payment system and offer liquidity to their customers. Amidst these structural shifts, there are new regulations in place for money-market mutual funds and anticipated changes in bank-liquidity regulations resulting from the failure of Silicon Valley Bank in 2023.
Changes over time also involve fluctuations in the demand for different types of liabilities held by the Federal Reserve, such as money-fund investments at the Fed’s Overnight Reverse Repurchase Facility and government deposits at the Fed. Based on our research findings, it appears that the Federal Reserve can greatly reduce uncertainty regarding the minimum level of reserves in the banking system by carefully timing intraday payments to the largest dealer banks. When payments to these banks experience a considerable delay compared to the long-term average delay, the Federal Reserve will recognize that it is appropriate to cease reducing its balance sheet.
