The Federal Reserve’s next monetary policy shift could have an unexpected conflict with the central bank’s supervisory mandates for banks to hold liquid assets for a rainy day.
On June 1, the central bank will begin shedding assets from its nearly $9 trillion balance sheet, a process that will also reduce its liabilities, a sizable portion of which are reserves held by banks, and reducing those balances is not as simple as allowing Fed-owned securities to expire.
Banks have favored heightened reserve balances as a stress buffer in recent years. This is due to both their voluminous supply — with more than $4.1 trillion in the Fed system as of last November — as well as contemporary capital requirements.
In 2017, a stipulation from the international regulatory accord Basel III began requiring banks to have enough high-quality liquid assets to cover 30 days of stress. While Treasuries, government-backed mortgages and other assets technically qualify as high-quality, the ready liquidity offered by reserves have made them a favorite of banks and supervisors alike.
Because of this elevated uptake of reserves and the regulatory burden they ease, some market observers question how much of their Fed reserves banks will be willing to part with, and what this will mean for the Fed’s long term balance sheet aspirations.
“The really fundamental question will be, ‘Is the Fed, going forward, going to have to maintain a balance sheet consistent with providing reserve balances somewhere close to where they are now, because that’s the level that they’ve reached?’” said William Nelson, chief economist at the Bank Policy Institute and a former deputy director of monetary affairs for the Federal Reserve Board. “Or will it be able to shrink considerably below that?”
The Fed alone controls the supply of reserves available to banks, but if demand for them does not decrease commensurately, the scarcity could upend the central bank’s broader monetary objectives. That was the case during the last round of monetary tightening, which began in October 2017.
In September 2019, as reserves became scarce, interest rates in the overnight funding market were bid up by banks clamoring for liquidity. As a result, the Fed’s benchmark fund rate was driven up beyond its target range. The episode triggered additional asset purchases by the Fed to increase liquidity.
After peaking at just under $3 trillion in early 2015, the Fed only managed to get its reserve liabilities down to about $1.7 trillion before having to reverse course. The ordeal demonstrated that paring down reserve supplies would not be an easy task after years of balance sheet expansion, Mike Feroli, chief U.S. economist for JPMorgan said.
“One of the things learned in the last round of [quantitative tightening] was the degree to which the banking system had an apparently permanently higher demand for reserves than was believed prior to QT,” Feroli said.
Since 2019, the FOMC has operated under the objective of maintaining “ample reserves” in the system, enough for most banks to have holdings beyond what they need to cover payments. The Fed’s objective is to keep supply well ahead of potential demand spikes that would drive up interest rates involuntarily, thereby preserving its fund rate as the primary driver of monetary policy.
Last year, the Fed also created a standing repurchase agreement facility, or SRF, to serve as a backstop during future surges in liquidity demand. Similar to the discount window, the SRF allows banks to access overnight funds from the Fed by putting up Treasuries, agency debt or mortgage-backed securities as collateral. Last week, Bank of New York Mellon, HSBC and Wells Fargo Bank brought the list of counterparties to nine, joining Bank of America, Citigroup, Goldman Sachs and the New York branches of Natixis, Mizuho and the Canadian Imperial Bank of Commerce.
The Fed anticipates more banks joining the SRF as eligibility is opened up to a wider group of institutions. In its latest Senior Financial Officer Survey, conducted last November and released in January, the Fed found that 45% of eligible institutions surveyed were interested in becoming counterparties, as were five of the 14 executives whose banks were not yet eligible.
Even with the additional safety net of the SRF, the Fed has pledged to curtail its runoff efforts before reserves fall below the ample level. Its plan calls for letting up to $30 billion of Treasury securities run off monthly in June, July and August, with the cap doubling to $60 billion in September. Similarly, it will begin letting up to $17.5 billion of mortgage-backed securities mature before lifting that cap to $35 billion.
During the Mortgage Bankers Association’s Capital and Secondary Markets Conference on Monday, John C. Williams, president of the New York Fed, said the lack of prepayment activity in the mortgage market will likely keep the Fed from hitting its MBS runoff target once the cap increases.
“That’s a pretty big number,” Williams said. “Our own forecasts are that we wouldn’t see $35 billion in the future months. It’ll take years before we see that much payment on the mortgages, especially since the refi activity is lower because of higher interest rates.”
Still, the runoff promises to be the sharpest in the Fed’s 109-year history. Its 2017 plan took 12 months of gradual increases to hit monthly runoffs of $30 billion in Treasuries and $20 billion in MBS.
The Fed has not set an express target for the long-term size of its balance sheet, but it has stated it would like to significantly reduce its holdings to regain flexibility for handling future crises. Some market observers are skeptical it can achieve that goal without triggering an economic shock along the way.
Greg McBride, chief financial analyst for the aggregation site Bankrate, said he believes the balance sheet will find a permanent home around $7.5 trillion, pointing to the fact that the Fed was only able to shed about $600 million during its last tightening cycle. Also, even shedding at the maximum pace of $95 billion monthly would leave the central bank with more than $8 trillion of assets a year from now, he said.
“To think that you’re going to be able to pull trillions of dollars out of the system and not cause a recession or cause some other market dislocation is just not realistic,” McBride said.
Peter Earle, an economist with the non-partisan American Institute for Economic Research, believes the Fed will get its balance sheet closer to its pre-COVID level in the coming years, but he said it will likely have to sell assets to do so, an unprecedented move for the central bank.
Earle also expects the Fed’s balance sheet reduction will lead to at least a slowdown in economic activity, if not a recession. In that instance, he predicts the Fed will adjust its monetary policy to encourage banks to convert reserves into loans, but he notes such activity is typically imprecise.
“So many of these levers are basically binary. They’re digital. They’re on or they’re off, they’re up or they’re down, they’re left or they’re right,” he said. “And the remainder of the economy is not mechanistic like that. The way things actually happen in the economy, when human beings are involved, when money is at work, is very organic.”
For banks, the pressure point between the supply of reserves and their own capital requirements is a long-term planning issue. If the Fed sees banks continuing to favor deposits in the system, it can first reduce other liabilities, such as cash holdings from the Treasury Department and its overnight reverse repurchase facility. And some banks will welcome the chance to shrink their reserve balances.
The Fed’s November survey found that nearly half of respondents had begun reducing reserve holdings during the previous sixth months, while 40% said they planned to do so in the coming sixth months. Many banks wanted to reduce their reserves in order to buy more assets that provide better returns, while some respondents just wanted smaller balance sheets.
Some banks could even experience regulatory relief in a lower reserve environment. By absorbing the copious amounts of reserves and Treasuries that have been injected into the financial system during the past two years, many institutions have found themselves running up against the limits of their supplementary leverage ratios, which requires banks to hold a certain amount of Tier 1 capital against their total leverage exposures. Because reserves and treasuries count toward the leverage total despite being risk-free assets, the regulation became a binding constraint for some banks during the most recent round of quantitative easing.
The primary objective for reducing the balance sheet is to limit the Fed’s support of credit markets and tamp down future demand. But there are also other considerations at play, Earle said. An ever-expanding balance sheet runs the risk of being used for political gain, he said, particularly as the Fed and other agencies are increasingly drawn into partisan battles.
“The Federal Reserve’s balance sheet would become a wonderful plaything for political administrations,” Earle said. “You could easily see the Fed balance sheet being used to finance or to provide liquidity or to house securities for certain pet projects. One that comes immediately to mind is the Green New Deal, but there are many others on both sides of the aisle.”