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The Fed's Balance Sheet Reduction: Outlook, Market Implications, and Potential Strategies

Earlier this month, Federal Reserve Bank of Dallas President Lorie Logan surprised many investors when she told a meeting of economists that the U.S. Federal Reserve should slow the pace at which assets are allowed to run off its balance sheet. Any debate over Fed balance sheet policy could reverberate in markets and the broader economy, particularly in banking sector income and the shape of the U.S. Treasury yield curve.

Boosting the central bank balance sheet, a process known as quantitative easing (QE), and reducing it (quantitative tightening (QT)), are potent monetary tools, especially when interest rates are pressed against the effective lower bound. However, for reasons we’ll discuss below, the Fed’s current QT hasn’t really tightened liquidity conditions in the traditional sense of draining reserves. At least not yet. Nevertheless, following Logan’s comments many forecasters now expect the Fed will stop QT sometime this year.

We believe that balancing the risk of unwanted volatility in money markets versus a clearly communicated preference to reduce the balance sheet would argue for the Fed to use a "taper and watch" strategy that continues to reduce the balance sheet and eventually drains reserves. That is, the Fed would step down the pace of balance sheet runoff, but wouldn’t stop the runoff until there are clearer signals of tighter liquidity conditions. Those signals include the effective fed funds rate (EFFR) drifting toward the higher end of the stated range, and broader overnight money market rates (e.g., the Secured Overnight Financing Rate (SOFR), broad general collateral repo rate (BCGR), or tri-party repo rates) sustainably trading above the interest rate paid on reserve balances (IORB). Unlike in 2019 when the Fed had to abruptly stop its balance sheet reduction program in response to a bout of money market volatility, none of these signals are present yet, suggesting to us that the Fed can continue to normalize its balance sheet likely through 2024, and possibly into 2025.

Focus on the Fed's reverse repo facility
In a 6 January speech to the annual meetings of the International Banking, Economics and Finance Association and the American Economic Association, Logan indicated that she would favor slowing the Fed's asset runoff when balances at its overnight reverse repo (RRP) facility decline toward zero.

The RRP facility swelled post-pandemic as banks shed reserves by pushing deposits into money market funds that could access the Fed’s facility. Due to regulations, banks found it capital-inefficient to hold the excess reserves created by the Fed’s emergency U.S. Treasury and agency mortgage-backed security (MBS) purchase programs.

More recently, the Fed has reduced the size of its Treasury and agency MBS holdings by not reinvesting maturing proceeds. As a result, RRP facility balances have fallen, while bank reserves have remained relatively stable. Since June 2022, the Fed’s holdings of Treasuries and agency MBS have declined by $1.2 trillion to about $7.7 trillion, while reserves have increased by $300 billion, as the nearly $1.7 trillion decline in the RRP more than offset the decline in asset holdings.

Meanwhile, additional Treasury issuance has been needed to fund sizable U.S. deficits. This, along with the additional issuance needed to fund the Fed’s maturities, has increased both T-bill issuance and general Treasury market collateral in the repo market. This has put upward pressure on front-end rates, enticing many money market funds to shift some cash out of the RRP facility to pursue higher yields elsewhere.

All of this is to say that front-end rates have responded to changes in Treasury issuance and other factors, while QT hasn’t tightened liquidity conditions yet, through lower reserve levels.

Abundant, ample, or scarce reserves?
The emergence of month-, quarter-, and year-end pressures in money markets suggests that although reserves have increased since June 2022, money markets may be behaving as if they are "no longer in a regime where liquidity is super abundant and always in excess supply for everyone," as Logan put it. Still, outside of those periods, money market rates have been relatively stable and trading below the IORB, signaling that although reserves may be less abundant, they are still more than ample.

The Federal Reserve aims to maintain an "ample" reserves regime with the smallest possible balance sheet. However, defining "ample" is challenging due to the lack of a specific minimum reserve level that indicates scarcity, and differing opinions among Fed officials on the necessary buffer above this level.

Regulations introduced after the global financial crisis further complicate the estimation of banks’ minimum comfortable reserve levels. These regulations mandate that the largest banks hold a certain percentage of their total assets as high-quality liquid assets, including reserves, while also maintaining minimum capital levels against those assets, through an overarching leverage ratio. With the Fed offering a 5.4% IORB on capital-efficient reserves, many banks have a preference to hold reserves above longer-duration securities. However, the way banks operate within these rules can change over time. As New York Fed President John Williams and others observed in a recent paper, these time-varying preferences tend to change banks’ demand for reserves, resulting in shifts in how money market rates behave.

Other econometric model-based estimates are similarly uncertain. For example, an analysis published by two Federal Reserve staffers (see Lopez-Salido, Vissing-Jorgensen, 2023), based on modeling money market rates using reserves and bank deposits, suggests minimum comfortable levels (i.e., the level of reserves where money market rates start trading above IORB) range anywhere from $2 trillion to $3.5 trillion. Other simpler metrics, including the ratio of reserves to systemwide banking deposits or assets, indicate that the system could handle reserve levels closer to $2.5 trillion to $3 trillion, which is consistent with estimates in the New York Fed’s annual report on open market operations.

Reserve concentration within the largest banks has also been studied, based on the idea that reserves that aren’t efficiently distributed around the system can result in bouts of money market volatility even when reserve levels remain ample. However, unlike in 2019, reserves are less concentrated in the largest banks today. At the time, the largest banks held almost 70% of reserves, according to Fed data, pushing smaller banks to pay higher rates for needed overnight funding. Today, those same large banks hold only 55% of reserves.

Net outlook for QT strategy
Given all of this uncertainty, what are the implications for monetary policy? We believe that balancing money market risk management versus a clearly communicated preference to reduce the balance sheet would argue for the Fed to use a "taper and watch" strategy: slowly reducing reserves in order to have time to react to the resulting changes in money markets. For example, the Fed could reduce the cap on Treasury maturities (which is now $60 billion/month) by $10 billion every quarter starting when RRP balances are close to zero (which could happen by midyear 2024) until the monthly pace reaches $30 billion – where it was in 2018–2019, although in March 2019 the Fed reduced this pace further. This strategy implies targeting a reserve level of $3.5 trillion (the top end of the range of estimates for the minimum level) by year-end 2024. If money market rate volatility remains low, the Fed could then continue reducing the balance sheet at a pace of $30 billion/month and target $2.5 trillion in reserves by year-end 2025, or even taper the monthly decline ahead of that, if money market rates begin to drift up relative to IORB.

Broader market implications: banking sector income, yield curve
How changes in the Fed’s balance sheet affect broader markets is a highly complex issue, but we see a couple of relatively clear channels.

First, banking industry interest income is likely to decline as the Fed lowers rates and reserves begin to fall due to QT, all else equal. We estimate that at a $3.5 trillion reserves level and the current 5.4% IORB, banks’ annual net interest income from reserves totals nearly $125 billion and accounts for about a third of industry net revenues on an annualized basis. That number could shrink considerably if reserves dropped to $2.5 trillion while the Fed is lowering rates.

Second, the Fed’s reduction of Treasury and agency MBS holdings is likely to help steepen the Treasury curve, all else equal. Term premiums should rise as the Treasury must issue more securities to the private sector to make up for what the Fed is no longer buying. Quantifying this effect, using the midpoint of the range of Fed and other academic estimates suggests that a 1 percentage point (ppt) of GDP increase in Treasury supply should raise 10-year term premiums by a little more than 5 basis points (bps). We estimate the difference between getting the balance down to $2.5 trillion versus $3.5 trillion is just above 3 ppts of GDP of additional Treasury supply, or around a 20-bp rise in 10-year term premiums. Translating that to the monetary policy rate by applying the beta over the current cycle suggests that the fed funds rate can decline by 40 bps relative to a scenario where the Fed concludes its balance sheet runoff sooner. Both higher term premiums and potentially lower front-end rates would likely steepen the curve.

Of course, if it turns out that the system needs more reserves, the opposite should also hold. Higher reserves should in theory continue to support banking sector income, while a higher-for-longer fed funds rate and lower Treasury issuance needs would have a flattening effect on the yield curve.

Under a "taper and watch" strategy, as we expect, the Fed could continue reducing its balance sheet while monitoring volatility and risks in markets, and adjust its strategy if needed. This would keep the Fed doing QT for longer, even if the pace is slower – something that would likely increase term premiums and help the Fed maintain relatively tight financial conditions as it normalizes front-end rates.

This report, like future reports, summarizes the vast array of data analysis that we do at PIMCO. Please don't hesitate to ask us about the underlying data and analysis. If you would like to reach out to us, please email [email protected].

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