The Fed sets an end to balance sheet reduction

| March 22, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The FOMC has been talking about the endgame for its balance sheet normalization program practically since it began reducing its portfolio, but not much was decided until this year.  Suddenly, the Fed has shifted into high gear, settling on the operating regime in January and then announcing at the March meeting a path to ending securities redemptions later this year.  The FOMC announcement may have sounded complicated, but it is a straightforward process.

Step 1: Continue managing excess reserves with IOER

The first thing that the Fed had to settle on was an operating regime for managing its policy rate.  Prior to the 2008 financial crisis, the Fed carefully added and drained reserves to keep the level at exactly the right amount to clear the funds rate market at its target.  After the crisis, the Fed moved to a system where it mainly uses its administered rates—primarily the interest on excess reserves, or IOER—to manage the funds rate and maintains a substantial stock of excess reserves.  This shift coincided with the Fed gaining the ability to pay interest on reserves.  The case for keeping a big stockpile of excess reserves in the banking system was also bolstered by the tightening of regulatory requirements associated with Dodd-Frank, forcing banks to hold a large amount of high-quality liquid assets including bank reserves. It is not surprising that the Fed announced in January that it would be sticking with the post-crisis operating regime.  Of course, this decision meant that the resting level for excess reserves would be large, reducing the amount of ultimate balance sheet reduction.

Step 2: Setting a level for excess reserves

Once that decision was settled, the Fed needed to decide on the right amount of excess reserves.  Fed officials have referenced surveys of banks conducted in 2018 by the New York Fed, which suggested that banks felt they needed around $1 trillion in excess reserves for the financial system to operate smoothly.  The FOMC introduced a wrinkle early this year when it discussed the likelihood of leaving a buffer of excess reserves above that $1 trillion level, since there was no way to know for sure exactly what the right number is.  The Committee professed a desire to play it safe by stopping balance sheet reduction well before actually arriving at the proper level of excess reserves, and then allowing growth in the demand side of the balance sheet (mainly currency) to gradually chew through the buffer.

The announcement Wednesday was consistent with that notion.  The level of excess reserves was about $1.5 trillion at the end of February, but the Fed announced that it will start winding down its securities redemption soon.  With the redemption schedule laid out this week, the Fed will reduce its securities portfolio by around $230 billion through the end of September, so when the balance sheet levels off on October 1, the amount of excess reserves in the banking system will be about $1.25 trillion—$1 trillion plus a sizable buffer.

Step 3: Managing the SOMA portfolio

In terms of securities redemptions, the status quo remains in place through April –monthly caps of $30 billion for Treasuries and $20 billion for MBS.  Beginning in May, the Treasuries cap is cut in half to $15 billion per month while the MBS cap remains at $20 billion.

The FOMC has decided that it will be content with the size of the balance sheet as of September 30. At that time, the balance sheet will be in the range of $3.5 to $3.6 trillion. Beginning in October, the Fed intends to keep the size of the balance sheet steady.  However, the balance sheet composition will continue to evolve.  The Fed has always said that, ideally, it would like to get back to a Treasuries-only securities portfolio.  So, the Fed will continue to allow its MBS portfolio to run off with a $20 billion monthly cap.  The innovation will be that MBS runoff will be re-invested into Treasuries beginning in October.  So, nothing changes for the MBS market, in May or in October.  For Treasuries, the Fed will go from a runoff of up to $30 billion per month through April to a runoff of up to $15 billion from May through September to a net purchase of up to $20 billion beginning in October.

Step 4: Remaining decisions

While the Fed has settled a number of questions about the future of the balance sheet, there are still a few more details that will need to be decided going forward.  There are two things in particular that focus will now turn to.

  • Treasury portfolio composition. Given the way that the Fed has passively run off its Treasury portfolio, it has not had any control of the composition of its securities.  Since the Fed has been rolling off its maturing securities and replacing them by buying new securities across the yield curve, the duration of its portfolio is creeping longer.  Moreover, the composition was already skewed longer, as the Fed sold off all of its bills in 2007 and extended the duration of its portfolio in 2011 and 2012 by selling its short-dated coupons and buying longer securities.
  • This week, the Fed provided some interim guidance.  The balance sheet statement from this week notes that purchases will “initially be invested in Treasury securities across a range of maturities to roughly match the maturity composition of Treasury securities outstanding.”  However, the Fed has plenty of time to revisit this.  Ultimately, I would expect that the Fed would want to skew its purchases to the shorter portions of the yield curve in an effort to bring its own portfolio into closer alignment with the duration of the Treasury market.  This would also give the Fed a little more liquidity/flexibility. It would be hard to liquidate a large amount of deep off-the-run Treasury bonds if the Fed ever needed to do so.  This is the next major shoe to drop, though the Fed does not need to settle on a strategy before October.
  • Chewing through the buffer.  The right ultimate level for excess reserves is not observable.  If we assume that it is $1 trillion, then the Fed’s sojourn at the September 30 balance sheet level could last for years.  The liability side of the balance sheet is likely to grow by somewhere in the neighborhood of $100 billion per year, so the Fed’s quarter-trillion-dollar buffer could last for a while.  In reality, nothing is quite as cut-and-dry as that.  The Fed will feel their way along and decide at some point, possibly arbitrarily, that excess reserves have fallen far enough.  Whenever that happens, the Fed will start buying even more Treasuries, as it will have to add Treasuries to both offset MBS runoff and to allow for the gradual growth in currency demand and required reserves.

john.killian@santander.us 1 (646) 776-7714

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