WSJ: When will the Fed end QT?

On October 28th, according to the WSJ, Federal Reserve officials will face a sudden and urgent decision this week, unrelated to interest rate cuts: whether to stop reducing the central bank's $6.6 trillion asset portfolio within days, or wait until the end of the year to make a decision. Just two weeks ago, the Fed seemed to be proceeding with its year-end decision as planned. Fed Chairman Jerome Powell gave a rare speech focusing primarily on the technical aspects of monetary policy, stating that the Fed might face the need to end its three-year asset reduction program "in the coming months." However, analysts say that since then, pressure in the overnight funding market has been greater than expected, potentially requiring an earlier halt. The debate over when to stop shrinking the balance sheet is quite different from the widely anticipated debate this week about whether to keep interest rates stable or cut them. Instead, the core of these discussions is how best to ensure the Federal Reserve maintains effective control over short-term interest rates. The Federal Reserve expanded its massive portfolio (sometimes called its balance sheet) during the 2007-2009 financial crisis and again purchased large amounts of government debt and mortgage-backed securities during the pandemic to stabilize markets and stimulate the economy. Since its balance sheet reached nearly $9 trillion in 2022, Federal Reserve officials have been gradually shrinking it by allowing securities to mature without replacing them. When the Federal Reserve buys securities, it creates reserves—electronic cash held by banks at the central bank. When the securities mature, these electronic currencies flow out of the financial system. Federal Reserve officials do not want the balance sheet to become too large because providing trillions of dollars in interest-bearing reserves to the banking system incurs political costs, such as paying huge interest payments to banks. But officials also need to control short-term interest rates. If interest rates rise unexpectedly, their volatility could affect mortgage rates, commercial loans, and the flow of credit in the economy. Officials lack experience in the delicate process of shrinking the balance sheet. Like a driver searching for an exit on an unfamiliar highway, if the wait is too long, officials might miss the exit. Doing so would only repeat what Fed leaders have been trying to avoid: in September 2019, the Fed inadvertently used too many reserves, causing overnight lending rates to spike. Officials hastily executed a confusing 180-degree turn, injecting cash back into the financial system. For the past three years, most of the funding for the Federal Reserve's balance sheet reduction did not come from banks, but from a separate deposit facility through which money market funds can hold cash. This facility has fallen from its peak of over $2.2 trillion in 2023 and is now virtually empty. With this buffer gone, every dollar on the Fed's balance sheet comes directly from bank reserves. In the days following Powell's October 14th speech, overnight rates strengthened as the government issued new debt, drawing cash from the banking system—equivalent to a large-scale withdrawal by major government clients. These funding pressures have pushed the Fed's benchmark federal funds rate higher within its target range of 4% to 4.25%, indicating that reserves are becoming less free to flow within the banking system. The pressure had eased briefly, but returned last week, at a time when mortgage-related cash flows typically suppress money market rates. Banks are using a Federal Reserve lending facility designed to act as a safety valve, allowing them to convert securities into reserves, again indicating that reserves are becoming less abundant. When Federal Reserve officials began shrinking their balance sheet in 2022, they agreed to stop shrinking when reserves were “slightly above” the level needed for smooth market functioning. Lou Crandall, chief economist at research firm Wrightson ICAP, said the Fed’s current policy framework is designed to detect recent market signals that the Fed is approaching its likely target for declining reserve levels. "The proximity alarm went off in the cockpit," he said. The Federal Reserve has slowed the pace of its balance sheet reduction twice, most recently in April, reducing securities by about $20 billion per month. Blake Gwinn, head of U.S. interest rate strategy at RBC Capital Markets, said that continuing to reduce the balance sheet for several more months may indicate that the central bank is not worried about recent volatility. "They can keep dragging it out, but I personally think it should have stopped six months ago," Gwinn said. "There's little benefit to doing so, and at the same time, the risk of increased volatility in the overnight lending market does increase slightly." The Federal Reserve currently allows up to $35 billion in mortgage-backed securities and $5 billion in U.S. Treasury securities to be removed from its portfolio each month. Since officials have indicated that once the reductions are complete, they want only U.S. Treasury securities on their balance sheet, they are likely to continue reducing mortgage-backed securities and invest all proceeds from maturing bonds in U.S. Treasury securities. At least one Fed official has hinted that they may prefer to extend the balance sheet reduction process. Vice Chair for Supervision Michelle Bowman stated in a September speech that she prefers to set a smaller balance sheet target in the long term than outlined in the 2022 principles, in order to minimize the Fed's influence in the markets and improve its ability to interpret market stress signals. Federal Reserve Governor Christopher Waller, who voted against the Fed's decision in March to slow the pace of Treasury bond reductions, defended the current operating framework in a chaired discussion this month. He stated, "We're at a point where," previously, banks had to compete with each other for reserves. The current framework wisely ensures that "people don't have to rummage through their couches for spare change at the end of the day to replenish their reserves. In my opinion, that's foolish," he said. After deciding when to stop portfolio reductions, officials will face other decisions, including when to allow it to grow again and which assets to purchase. The opposite of the Federal Reserve's assets (primarily U.S. Treasury bonds and mortgage-backed securities) are its liabilities, which include reserves, U.S. Treasury cash accounts, and physical currency. Even if the Fed stops reducing its assets, any increase in non-reserve liabilities will lead to a corresponding decrease in reserves. As a result, officials will ultimately have to decide when to resume purchasing securities to prevent further passive reductions in reserves.