Macro Update: What to Watch as Potential Factors that Could Lead to the End of Quantitative Tightening

Key Points:

• Explores complexities of QT and Fed officials’ signalling.
• Powell commits to post-2008 regime, maintaining ample reserves.
• December FOMC minutes highlight discussions guiding balance sheet runoff.
• Monitor SOFR-IORB spread, reverse repos, reserves, and Bank Term Funding.
• End of QT may support Treasuries while weigh on the dollar.

Introduction

The Federal Reserve's recent pronouncements on the future trajectory of Quantitative Tightening (QT) have injected a new dimension of complexity into the financial landscape. The post-FOMC press conference on December 13, 2024, featuring Federal Reserve Chair Powell's insights, initially suggested a status quo in the pace of QT. However, the subsequent release of FOMC minutes unveiled a nuanced tapestry of perspectives within the Committee. This article undertakes an exploration of the technical intricacies that may guide the Federal Reserve's decision-making process regarding the reduction of its securities holdings and therefore its balance sheet, a phenomenon colloquially known as quantitative tightening.

Understanding Powell's Perspective and the Ample Reserve Regime

Fed Chair Powell's declaration on December 13 that the Federal Reserve is presently "not talking about altering the pace of Quantitative Tightening (QT) right now" provided a glimpse into the central bank's current stance. Powell elucidated that the reverse repo facility's (RRP) take-up had been rapidly decreasing, resulting in a surge in reserves despite the shrinking size of the Fed’s securities portfolio and its balance sheet. He outlined the Fed's plan to continue the balance sheet runoff when the RRP levels out, allowing reserves to begin their decline.

Powell emphasized the Fed's intention to diminish its securities holdings as long as reserve balances, i.e., deposits held by banks at the 12 Federal Reserve banks, are "somewhat above the level judged to be consistent with ample reserves." He went on to say that we are "not at those levels… with reserves close to [$]3.5 trillion."

After the Global Financial Crisis in 2008, the Fed transitioned from a scarce reverse regime to an ample reserve regime. In a scarce reserve regime, banks kept only minimal reserves at the Fed to fulfill regulatory requirements and facilitate daily payments. Neither required reserves nor excess reserves earned interest, so banks aimed to lend out as much as reasonable given their anticipated payment obligations during the day. The reserves held by the banking sector as a whole at the Fed were less than $50 billion. Under the scarce reserve regime, overnight interest rates were sensitive to the amount of excess reserves available for banks to lend out in the unsecured Fed Fund market and the secured repo markets. The Fed conducted open market operations, such as repos and reverse repos, to affect the amount of excess reserves in the system and to control the policy overnight Fed Fund rate.

Under the ample reserve regime currently we are in, overnight interest rates are no longer reacting to the changes in reserve balances as the latter is ample. Changes in reserve balances, except in some cases where the supply of reserves falls dramatically within a short period or the demand for reserves soars due to external shocks, will not move the overnight policy Fed Fund Rate. Therefore, the Fed’s open market operations lost their efficacy in controlling the policy Fed Fund Rate.

As a result, the Fed has since adopted two administered rates to maintain the overnight Fed Fund targeted range that it announces. The first is the Interest on Reserve Balances (IOBR), an administered rate that the Fed pays for all reserve balances, as much as the banks want to place at the Fed. Since 2020, the Fed has even completely abandoned the minimum requirement of reserves so there is no longer distinguishment between required and excess reserves but only reserve balances. The IOBR is currently 5.4%, which is 10 bps below the upper bound of the targeted range of the overnight Fed Fund. The second administered rate is the fixed award rate that the Fed pays for reverse repo transactions (RRP rate) with domestic non-bank institutions, including Federal agencies and money market funds, for unlimited amounts. The RRP rate currently is 5.3%, which is 5 bps above the lower bound of the targeted Fed Fund Rate.

A full discussion of the ample reserve regime would require much more space than this short article. In brief, Powell is conveying that the Fed will continue to operate under the post-2008 ample reserve regime and will cease quantitative tightening before the reserve balance falls to a level that may no longer be considered ample.

When Will Reserves Be at Risk of Not Being “Ample”?

In the December FOMC minutes subsequently released on January 3, 2024, it was revealed that " several participants remarked that the Committee’s balance sheet plans indicated that it would slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level judged consistent with ample reserves. These participants suggested that it would be appropriate for the Committee to begin to discuss the technical factors that would guide a decision to slow the pace of runoff well before such a decision was reached in order to provide appropriate advance notice to the public.”

In Fedspeak, the term “several participants” signifies a perspective distinct from the dominant view, which is typically characterized by terms such as "all," "all but one," "almost all," "generally," "most," "majority," "many," or "some," before descending to the quantitative term “several,” as illustrated in this explanatory note from the Fed. However, it is now the time for investors to pay attention to the technical factors that may determine the adequacy of reserves.

Two pivotal factors, according to Powell, influence the decision-making process. Firstly, the amount of reverse repos on the Fed's balance sheet serves as an indicator. As this balance approaches zero, it ceases to act as a buffer, leading to a decline in bank reserves as the Fed continues to run off its securities holdings. Secondly, Powell highlighted the critical level of reserve balances, signaling a need to slow down or halt the reduction when reserves fall to a level slightly above what is considered ample.

Illustrating the Dynamics

As of January 3, 2024, the size of the Fed’s balance sheet was $7.73 trillion. It consisted of two major categories on the liabilities side: $3.46 trillion in bank reserve balances with the 12 Federal Reserve banks, and $4.27 trillion in other factors, including $0.72 trillion in reverse repos (excluding foreign official and international accounts) and $0.74 trillion in Treasury General Account (TGA) balances at the Fed.

Figure 1 below illustrates that as the Fed trimmed its balance sheet, bank reserves increased even when the Treasury General Account rose. The rundown of securities holdings reduced the size of the Fed’s balance sheet, causing liabilities to shrink by the same amount. Since money market funds invested less in reverse repos with the Fed as they took up more Treasury bills, their funds were diverted from sitting on the Fed’s balance sheet to the Treasury General Account when they bought Treasury bills from the Treasury in actions or to bank reserve balances if they bought Treasury bills in the secondary markets. The increasing supply of T-bills from the Treasury and anticipation of the Fed cutting rates in 2024 contributed to this shift. Additionally, when the Treasury spent its money, the fund flowed from the Treasury General Account at the Fed to banks and ended up as reserve balances at the Fed. Therefore, as long as there were still large reverse repo balances and mutual funds were buying Treasury bills, the runoff of the Fed’s balance sheet did not affect the reserve balance. For a more detailed illustration of the mechanism and accounting, readers can refer to our previous article.