Barclays says Fed may have to slow or stop balance sheet trimming in 2023
US Federal Reserve officials give little guidance on how long and how far they plan to go in cutting the holdings
20 October 2022 - 17:50
byMichael S. Derby
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The US Federal Reserve building is pictured in Washington D.C, US. Picture: REUTERS/JASON REED
The US Federal Reserve may have to slow or stop shrinking its nearly $9-trillion balance sheet sooner than many now expect, according to a report from Barclays.
The investment bank’s analysts wrote this week that the current pace of the drawdown likely needs to change in the first half of next year. That’s because if the Fed were to press forward with letting its balance sheet shrink, bank reserves would by end-2023 fall to levels that would complicate maintaining firm control of the federal funds rate, the US central bank’s primary tool for influencing the direction of the economy.
So far, Fed officials have given little guidance as to how long and how far they plan to go with cutting the holdings, noting only that they see it as an extended process heading to an uncertain end. “I don’t know what the final end point is of our balance sheet,” Minneapolis Fed president Neel Kashkari said on Wednesday, but “we have a ways to go”.
That end state of the process is tricky due to a number of factors. But the biggest uncertainty is that it is unclear when the financial system moves from ample levels of bank reserves to one where they are scarce.
Scarce reserves mean the federal funds target rate can become volatile, which central bankers do not like. When reserves ran low in September 2019, the Fed was forced to intervene to bolster them through asset-buying and temporary liquidity injections.
The Barclays analysis comes as the Fed tightens its monetary policy stance on two fronts. Its bid to lower inflation, which has been running at 40-year highs, is driving officials to push up their federal funds target rate range aggressively, with increases likely to spill over into next year.
Withdrawing stimulus has also meant shrinking the size of the Fed’s balance sheet. From a size of $4.2-trillion in March 2020, the holdings peaked at around $9-trillion last spring due to bond-buying stimulus efforts tied to the coronavirus pandemic. The Fed started drawing down its holdings by $95bn per month in September, with holdings now at $8.8-trillion. Amid that decline, bank reserves have been falling.
The Barclays report said that due to financial-system changes, “total reserve levels are likely to come under pressure at higher levels, which means the current level of bank reserves is probably closer to reserve scarcity than might have been the case before 2015”.
The path the Fed is on now will probably shave just more than $1-trillion off its balance sheet next year, which means reserves will become an issue for monetary policy before the end of the year, the report said.
“Our sense is that these changes to the shape and location of the demand curve for bank reserves will mean that the Fed reaches ‘ample’ much sooner than it expects,” hitting that mark in the first half of 2023, the report said.
The Barclays report acknowledges the Fed could tweak the settings of its rate control toolkit or resort to other measures that could buy it some space on the reserves issue. But those sorts of things only offer a temporary respite, which makes altering the pace of the balance sheet drawdown the more valuable tool.
Support our award-winning journalism. The Premium package (digital only) is R30 for the first month and thereafter you pay R129 p/m now ad-free for all subscribers.
Barclays says Fed may have to slow or stop balance sheet trimming in 2023
US Federal Reserve officials give little guidance on how long and how far they plan to go in cutting the holdings
The US Federal Reserve may have to slow or stop shrinking its nearly $9-trillion balance sheet sooner than many now expect, according to a report from Barclays.
The investment bank’s analysts wrote this week that the current pace of the drawdown likely needs to change in the first half of next year. That’s because if the Fed were to press forward with letting its balance sheet shrink, bank reserves would by end-2023 fall to levels that would complicate maintaining firm control of the federal funds rate, the US central bank’s primary tool for influencing the direction of the economy.
So far, Fed officials have given little guidance as to how long and how far they plan to go with cutting the holdings, noting only that they see it as an extended process heading to an uncertain end. “I don’t know what the final end point is of our balance sheet,” Minneapolis Fed president Neel Kashkari said on Wednesday, but “we have a ways to go”.
That end state of the process is tricky due to a number of factors. But the biggest uncertainty is that it is unclear when the financial system moves from ample levels of bank reserves to one where they are scarce.
Scarce reserves mean the federal funds target rate can become volatile, which central bankers do not like. When reserves ran low in September 2019, the Fed was forced to intervene to bolster them through asset-buying and temporary liquidity injections.
The Barclays analysis comes as the Fed tightens its monetary policy stance on two fronts. Its bid to lower inflation, which has been running at 40-year highs, is driving officials to push up their federal funds target rate range aggressively, with increases likely to spill over into next year.
Withdrawing stimulus has also meant shrinking the size of the Fed’s balance sheet. From a size of $4.2-trillion in March 2020, the holdings peaked at around $9-trillion last spring due to bond-buying stimulus efforts tied to the coronavirus pandemic. The Fed started drawing down its holdings by $95bn per month in September, with holdings now at $8.8-trillion. Amid that decline, bank reserves have been falling.
The Barclays report said that due to financial-system changes, “total reserve levels are likely to come under pressure at higher levels, which means the current level of bank reserves is probably closer to reserve scarcity than might have been the case before 2015”.
The path the Fed is on now will probably shave just more than $1-trillion off its balance sheet next year, which means reserves will become an issue for monetary policy before the end of the year, the report said.
“Our sense is that these changes to the shape and location of the demand curve for bank reserves will mean that the Fed reaches ‘ample’ much sooner than it expects,” hitting that mark in the first half of 2023, the report said.
The Barclays report acknowledges the Fed could tweak the settings of its rate control toolkit or resort to other measures that could buy it some space on the reserves issue. But those sorts of things only offer a temporary respite, which makes altering the pace of the balance sheet drawdown the more valuable tool.
Reuters
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