To The Moon

Though the Federal Reserve stopped raising interest rates last summer, it is quietly tightening monetary policy through another channel: shrinking its $7.7 trillion holdings of bonds and other assets by around $80 billion a month.

Now that, too, may change. Fed officials are to start deliberations on slowing, though not ending, that so-called quantitative tightening as soon as their policy meeting this month. It could have important implications for financial markets.

The Fed can shrink its holdings by selling bonds or, as it has preferred, allowing bonds to mature and "run off" its balance sheet without buying new ones. Runoff increases the supply of bonds that investors must absorb, putting upward pressure on long-term interest rates. Slowing runoff reduces that upward pressure.

But whereas the Fed expects to cut short-term interest rates this year because inflation has fallen, its rationale for tapering bond runoff is different: to prevent disruption to an obscure yet critical corner of the financial markets.

Five years ago, balance-sheet runoff sparked upheaval in those markets, forcing a messy U-turn. Officials are determined not to do that again.

Several officials at the Fed's policy meeting last month suggested beginning formal conversations soon, so as to communicate their plans to the public well before any changes take effect, according to minutes of the meeting. Officials have indicated that changes aren't imminent and that they are focusing on slowing -- not ending -- the program.

The Fed began building up its huge stash of bonds during the 2008 financial crisis. At the time, it had already cut the short-term interest rate to near zero. Buying bonds, or "quantitative easing," was intended to deliver further stimulus by lowering long-term rates.

When the Fed buys a bond from a bank or a bank's customer, it pays for it through the electronic equivalent of printing money: crediting the bank's account at the Fed. As its bondholdings grew, so did this electronic cash, called reserves.

In 2017, when the Fed began shrinking its holdings, it also drained those reserve deposits. Officials had never managed something like this before and weren't sure how long to let the process run.

A bank uses reserves to manage transactions between itself, its customers, other banks, and the central bank. The Fed and private-sector forecasters thought banks had far more than needed for this. But in September 2019, a sharp, unexpected spike in a key overnight lending rate suggested reserves had dwindled to the point they were either too scarce or difficult to redistribute across the financial system. The Fed began buying Treasury bills to add reserves back to the system and avoid further instability.

In 2020, the Covid-19 pandemic created a huge dash for dollars. To prevent markets from seizing up, the Fed resumed buying huge quantities of securities. It stopped buying in March 2022 and three months later set the process into reverse, once again shrinking the portfolio.

Policymakers have several reasons to consider slowing runoff. First, the Fed is shrinking its Treasury holdings by $60 billion a month -- twice as fast it did five years ago. Continuing to run at this rate raises the risk that the Fed drains reserves so quickly that money-market rates jump as banks struggle to redistribute a dwindling supply of reserves.

Slowing the pace of the runoff later this year might allow the Fed to continue the program for longer than otherwise by "reducing the likelihood that we'd have to stop prematurely," Dallas Fed President Lorie Logan said in a recent speech.

Logan's views are likely to carry weight because she was the New York Fed executive in charge of managing the central bank's portfolio between 2019 and 2022.

Second, there are signs that the cash surplus in money markets is rapidly diminishing. The Fed allows money-market firms and others to park extra cash that would otherwise end up in reserves in an overnight reverse repurchase facility. The facility has shrunk by around $1 trillion since late August to around $680 billion. Logan endorsed slowing runoff once that facility is nearly drained of cash because, after that, forecasting demand for bank reserves will be more uncertain.

The faster-than-expected decline in the overnight reverse repurchase facility's balances is spurring the Fed's movement toward contingency planning around how to slow runoff.

It has been a surprise to everyone that overnight reverse repurchase balances have fallen this quickly and that reserves have actually increased over this period," said Brian Sack, who managed the balance sheet as a senior executive at the New York Fed from 2009 to 2012.

Third, officials have indicated they will leave the banking system with more reserves than they did when they shrank the balance sheet five years ago.

Research co-written in 2022 by John Williams, president of the New York Fed, found that banks' demand for reserves had been trending higher over the past decade. It said money-market rates began to rise once reserves fell below 13% of banks' total assets. Today, that would correspond to $3 trillion, below the current $3.5 trillion but well above the $1.4 trillion (8% of bank assets) reached in September 2019.

Officials say they are going to rely more on market signals in identifying the right level of reserves. "Last time, we had lots of estimates of where we thought that terminal level of reserves was, and our estimates were too low," Philadelphia Fed President Patrick Harker said in an October interview. "At the end of the day, the market will dictate where we are."

Market participants say the Fed needs to manage runoff carefully because banks may need more reserves than it realizes. That is because of regulations that require banks to hold higher-quality assets to meet unexpected demands for cash. Moreover, for 15 years banks have had so much cash as a result of the Fed's operations that the interbank market where banks lent reserves to each other has atrophied. Market participants and Fed officials are less confident reserves can quickly go from banks with extra to those in need.

Still, Fed officials probably don't feel they need to be rushed into a decision, said Sack. "At this point, we are not seeing signs that would indicate that the balance-sheet runoff needs to be slowed right away," he said.