Any real economy crunch from the U.S. Federal Reserve’s balance sheet rundown may have been softened to date, but the air is rapidly escaping from one of its key cushions. Last week’s rhetorical shift by the Fed raises questions about how long 2023’s commercial bank reserves at the Fed can remain stable, according to credit and liquidity watchers. Debate centers on the financial liquidity management related to the Fed’s ‘quantitative tightening’ (QT), in which it has been gradually offloading its $7.8 trillion balance sheet hoard of bonds and bills over the past 18 months. The QT process effectively bought bonds from banks, credited them with commercial bank reserves held at the Fed, and allowed banks to lend to businesses and households. While the process has been underway since mid-2022, there are concerns about the stability of commercial bank reserves at the Fed, especially as the Fed’s daily reverse securities repurchase facility (RRP) has been deflating rapidly. Daily reverse repo totals have dropped by approximately $1.6 trillion over the past three months alone, and if this pace continues, the RRP may be depleted by March. This could have significant implications for U.S. bank credit and asset prices, particularly as liquidity analysts have been puzzled by the lack of adverse impact thus far.
Solomon Tadesse of Societe Generale explains that the impact of QT on lending to the broader economy depends on how it erodes bank reserves, and the presence of the RRP buffer zone has mitigated this effect so far. In the previous period of QT from 2017-2019, bank reserves declined alongside the overall reduction of the Fed’s balance sheet. However, during the current QT campaign, bank reserves have remained unchanged despite a reduction of approximately $1.1 trillion in the Fed’s balance sheet. As the RRP continues to deplete, Tadesse warns that QT will start to impact reserves more sharply, potentially leading to a liquidity squeeze that could affect loan growth and asset prices.
The opinions on the potential impact of QT are mixed. New York Fed chief John Williams asserts that the depletion of the RRP is as designed and reserve scarcity is not imminent. On the other hand, there are growing concerns that the combination of falling credit demand and supply could have a greater negative impact on the U.S. economy next year than what has been seen so far. This may prompt the Fed to change its policy approach. Other liquidity experts believe that the impact on markets is influenced by global liquidity, and CrossBorder Capital’s latest updates indicate that nominal global liquidity levels are increasing, nearing the highest levels of the year.
Overall, there is growing speculation about the potential consequences of the Fed’s balance sheet rundown and the depletion of the RRP. While some experts believe that the impact on bank reserves and the broader economy has been muted so far, there are concerns that as the RRP cushion diminishes, the effects of QT may become more pronounced. The upcoming months will be crucial in determining the fallout and the path the Fed decides to take.
