by Chris Black
Chair Powell’s intention to separate interest rate and balance sheet policy will likely extend quantitative tightening to well into 2025.
The Fed has historically linked their interest rate and balance sheet policy together so that the two have always moved in the same direction.
But Chair Powell appears to endorse the view (www.youtube.com/live/HEzNuyuXULY?si=wPsVwfItAL7oS-Xw&t=2593) that QT can continue when rate cuts are intended to normalize interest rates rather than to ease policy.
With current policy perceived to be very restrictive, rate normalization may not be reached for some time.
This suggests that reserve balances remain the binding constraint for QT (i.e. what will end QT).
Reserve levels are a hard constraint on QT, but they are unlikely to be a binding constraint for at least 18 months.
The Fed operates an “ample reserves (www.federalreserve.gov/econres/notes/feds-notes/implementing-monetary-policy-in-an-ample-reserves-regime-the-basics-note-1-of-3-20200701.html)” framework where it seeks to ensure that banks have more reserves than they need.
Reserves are deposits commercial banks hold at the Federal Reserve.
However, the Fed does not know how many reserves the banking sector needs.
The current level is $3.5t (fred.stlouisfed.org/series/WRBWFRBL) and a prior Fed report has estimated the minimum level to be roughly 8% of nominal GDP (www.newyorkfed.org/medialibrary/media/markets/omo/omo2021-pdf.pdf) ($2.2t today).
Fed officials thus widely perceive reserve levels to be very high and have been comfortable running an aggressive QT, which mechanically reduces reserve balances (fedguy.com/quantitative-tightening-step-by-step/).
Some Fed officials have even expressed a broad view on minimum reserve balances to include RRP balances, which would bring total levels today to $4.4t.
Reserves balances are likely to remain comfortably above any measure of minimum reserves for some time even without combining RRP balances.
Reserve balances have been gradually rising and will continue to rise as RRP balances decline towards 0 in the coming months.
On-going bill issuance and steady private repo demand are steadily channeling RRP balances into the banking system.
When the RRP is emptied in the first half of next year, reserve balances should be around $4t.
Under a very conservative minimum reserve balance assumption of $3t (11% nominal GDP) and an actual QT rate of $75b per month, QT could continue for another year after without running into reserve constraints.
This suggests reserve levels would not be binding until mid-2025, with a potential tapered QT scenario further extending the horizon.
Chair Powell has suggested de-linking interest rate and balance sheet policy from each other, and re-linking them to the concept of “normalization.”
Under this view, QT can continue during rate cuts as long as the cuts are intended to normalize policy rather than to ease policy (add accommodation).
Fed officials typically judge the stance of policy relative to a theoretical “neutral rate,” where policy rates higher than the neutral rate are considered restrictive.
The December dot plot (www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20231213.pdf) suggests this neutral rate is perceived to be 0.5%, which is notably lower than current marked implied medium term real rate of 1.75% (fred.stlouisfed.org/series/DFII5).
John Williams, President at the New York Fed, has even remarked (www.newyorkfed.org/newsevents/speeches/2023/wil231130) that based on this framework, the current stance of policy is the most restrictive in 25 years.
A normalization of interest rate policy would first imply a move away from very restrictive towards less restrictive and finally to neutral.
The normalization constraint is subject to enormous economic uncertainty, but may not be triggered until after reserve levels reach a minimum.
The stance of interest rate policy is currently very restrictive, but is expected to become less restrictive from expected rate cuts rates next year.
Note there is also potential for the recent decline in rates to spur another wave of economic activity and extend restrictive policy.
While an economic accident that prompts emergency easing is always possible, recent economic performance (www.bea.gov/data/gdp/gross-domestic-product) suggest a strong degree of economic momentum.
A continuation of the current soft landing scenario implies that QT could run until the reserve constraint is triggered in 2025.
The eventual end of QT could be an extended process that begins with tapering and ends in further out in the future.
The Fed ended its first QT (www.federalreserve.gov/newsevents/pressreleases/monetary20190320c.htm) by first announcing a taper in March 2019 and then ending the process four months later.
But at that time the Fed had seen repo rates spike, perceived the banking system to already be at minimum reserve balances, and was eager to stop QT.
With the benefit of hindsight, the Fed would likely end QT this time with a taper far in advance of their estimates of minimum reserve balances.
The rate of QT today is much more rapid than in 2019, so the taper could be staggered over a period of time.
This scenario indicates tapering could begin in late 2024 and extend far into 2025.
Market participants may be underestimating the determination of central banks to shrink their balance sheet by anticipating a 2024 end to QT (home.treasury.gov/system/files/221/TreasuryPresentationToTBACQ42023.pdf).
The Fed’s has already published its official position to conduct policy primary through interest rates (www.federalreserve.gov/newsevents/pressreleases/monetary20220126c.htm) rather than the balance sheet.
The ECB has also recently expressed determination to shrink its balance sheet by de-linking interest rate policy from balance sheet policy (www.ecb.europa.eu/press/pressconf/2023/html/ecb.is231214~df8627de60.en.html).
There appears to be a shared view that central bank balance sheets are too big.
With the recent decline in global bond yields, the central banks have a lot more space to achieve those goals.