Quantitative Tightening endgame

Stephen Stanley | November 1, 2024

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.

It seems that some Wall Street analysts have been predicting that the Fed would soon end its balance sheet reduction program since not long after it got started in 2022.  While the FOMC elected earlier this year to cut the pace of Treasury redemptions sharply, the Fed continues to draw down its securities portfolio.  Consensus expectations suggest that we are fast approaching an end to quantitative tightening.  But how close is the Fed to rightsizing its balance sheet?

Determining the proper size of the Fed’s balance sheet

In the aftermath of massive securities purchases during and after the pandemic, the Federal Reserve’s balance sheet ballooned to record levels.  At its peak in the spring of 2022, the Fed’s balance sheet swelled to nearly $9 trillion, up from $4 trillion at the end of 2019.

The asset side of the Fed’s balance sheet consists primarily of Treasury and agency mortgage securities, along with a litany of smaller line items such as discount window loans, central bank swaps, and reserve assets such as foreign currency and gold.

The liability side of the balance sheet consists of the uses for the liquidity that the Fed provides.  This includes currency in circulation, the Treasury’s cash balance, reverse RPs, and bank reserves, along with a handful of smaller line items.

Over time, the demand for currency is relatively easy to predict as it expands more or less in tandem with the nominal growth in the economy.  The Treasury’s cash balance fluctuates considerably in the short run, but it is also fairly straightforward to project over longer time horizons.  Thus, broadly speaking, the trick for the Fed is that policymakers and analysts at the central bank have to figure out how much liquidity the financial system needs to operate comfortably.

The problem is that banks’ demand for reserves evolves over time.  Certainly, compared to the era before the Global Financial Crisis, banks are required to hold vastly higher levels of reserves to satisfy the more stringent rules imposed by regulators.  In addition, banks in modern times also desire a significant margin of precautionary liquidity to guard against runs and other unexpected draws on cash.  Once the Fed engages in a large amount of balance sheet expansion and severs the tie between the supply and demand of liquidity, bringing the system back into alignment requires a lot of guesswork and perhaps some trial and error.

Although the FOMC and policymakers have said little about this in recent months, there is a growing presumption in the financial market community that the Fed is nearing the proper size of its balance sheet, so that the Fed’s quantitative tightening is thought to be in its late stages.

Defining the consensus

Private sector analysts are making all of the same guesses as Fed officials about how large the Fed’s balance sheet needs to be.  There are two sources that we can tap to define a private sector consensus.

First, the New York Fed conducts a survey of primary dealers in advance of each FOMC meeting in order to help the committee understand what the financial community expects for the economy and monetary policy (full disclosure, I participate in this survey).  Since 2022, the survey has asked various questions about expectations for the size of the Fed’s balance sheet when the FOMC stops shrinking it.  Exhibit 1 shows the median estimate at various dates for the ultimate size of the Fed’s securities portfolio (the asset side of the balance sheet) and the sum of bank reserves and reverse RP take-up (the key swing factor on the liability side) when the Fed chooses to stop contracting the balance sheet.

Exhibit 1: Median primary dealer expectation of ultimate Fed balance sheet size

Source: NY Fed.

Early on in the quantitative tightening (QT) process, primary dealers had elevated assumptions about the eventual landing point.  After the SVB failure in early 2023, there was a natural view that banks would want to hold more precautionary reserves.  However, by early 2024, expectations receded somewhat and have stabilized at just under $6.4 trillion for the securities portfolio and $3.25 trillion for bank reserves plus the RRP take-up.

As I have laid out in several pieces over the past two years, I have been consistently calling for a somewhat smaller balance sheet than the Street consensus.  My most recent responses to the New York Fed survey for these two variables were $6.15 trillion for securities and $3.12 trillion for bank reserves plus RRP.

The latest readings for these two measures (as of October 23) were $6.64 trillion and $3.50 trillion, respectively. Relative to the latest median projection, the Fed has moved to within $300 billion of rightsizing its securities portfolio and to within about $250 billion for financial system liquidity.

An alternative source for gauging Street expectations is the quarterly primary dealer survey conducted by Treasury in advance of each refunding announcement (I also participate in this one).  The Fed’s redemption strategy impacts Treasury’s borrowing needs from the public, so Treasury debt managers have been asking about projections for Treasury redemptions since QT began.

Exhibit 2 shows the evolution of primary dealer expectations for Treasury redemptions.  As with the NY Fed results, primary dealer analysts have slowly and grudgingly conceded over time that QT was likely to extend longer and reach a larger cumulative amount than they had previously thought.

Exhibit 2: Median primary dealer expectation for Fed’s Treasury redemptions

Source: Treasury Department.

The latest expectation that QT would total $150 billion in the fiscal year that began October 1 (the median expectation for FY2026 has always been zero) suggests that the Fed will soon end its Treasury redemptions.  The current monthly pace of redemptions is $25 billion.  If we assume that the Fed maintains that pace through the end of the calendar year, that would account for $75 billion.  Then, the median expectation suggests either that the Fed would continue to redeem Treasuries at a pace of $25 billion per month through March and then stop cold turkey or that the Fed would taper down the pace of purchases in such a way that it redeemed only $75 billion more in Treasuries after January 1.  In either case, the median expectation suggests that QT will soon be almost over.

Just to square the results from the first two exhibits, in addition to Treasury redemptions, the Fed is running down its MBS portfolio at a pace of around $15 billion per month.  Thus, maintaining the current strategy through March 2025 would reduce the securities portfolio by around $240 billion ($25 billion in Treasuries times six plus $15 billion in MBS times six).  That is broadly consistent with the SOMA portfolio estimate in Exhibit 1, which is about $265 billion below the current level.

I continue to expect more Treasury redemptions than the median.  My current projections call for the Fed to sustain the current pace of $25 billion per month through March and then gradually taper to zero, eventually halting QT at the end of calendar 2025.  My projections call for a total of $285 billion in Treasury redemptions from October 1, 2024, i.e., $135 billion more than the consensus.

Guessing where to stop

Just to repeat, everyone that is making a projection is taking a guess as to what level of liquidity the financial system needs to operate smoothly.  And to underscore, these are truly guesses.  My estimates were derived based on broad guesstimates about what level of reserves as a percentage of GDP would be demanded, but the reality is that we will not know the answer for sure until we get there, and money market trading begins to signal tighter liquidity.

Thus, while the median primary dealer analyst thinks that the Fed is growing very close to the end of QT and I think we are nearing the late stages but with a considerable way to go, in fact everyone could be off by more than a little.  The New York Fed has begun publishing an array of money market metrics that should serve as early warning signs that the excess in liquidity is dissipating.  So far, these measures have yet to budge, suggesting that for now, liquidity remains significantly above the necessary levels.

Dallas Fed President Lorie Logan is an authority on these questions, as she managed the SOMA for the New York Fed for a number of years, including during the pandemic.  So, understandably, the FOMC seems to be leaning heavily on her expertise.  She was the first official to push to curtail the pace of redemptions this year, as a way to improve the Fed’s chances to avoid an overshoot, as occurred in 2019, a decision that was implemented by the Committee in the spring.

Thus, President Logan’s comments on this topic carry serious weight, at least for me.  She revisited the balance sheet in a speech to SIFMA on October 21.  She made two remarks that I thought were especially notable.  First, she repeated her view that the proper level of the RRP program in equilibrium is essentially zero.  She noted that the RRP facility was established as a backstop and should not carry significant balances as a matter of course.  This runs against the grain of the projections of most Street analysts.

Second, and more importantly, Logan weighed in on where bank reserves may need to settle.  She said: “Reserve balances are around $3.2 trillion, compared with around $1.7 trillion in early 2020.  The economy and financial system have grown, and the dash for cash at the start of the pandemic as well as the banking stresses in March 2023 may have led banks to increase their demand for liquidity.  Still, I think it’s unlikely banks’ liquidity demand has nearly doubled in half a decade.”  There is no explicit forecast here, but the tone of her comments suggests to me that she does not rule out that the “proper” level of reserves could be hundreds of billions of dollars lower than the consensus projection.

Debt ceiling warning

If the Fed will be nearing the appropriate level of the balance sheet in 2025, as the consensus expects, then there is an eerie similarity to 2019, the last time (and only time before the current episode) that the Fed was shrinking the balance sheet back to the proper level after conducting a series of securities purchases.

Recall that I mentioned the Treasury’s cash balance in the above rundown of key balance sheet liability items.  This ended up playing a key role in the 2019 overshoot that led to a seizing up of money markets.  When the Treasury’s cash balance increases, for a given level of liquidity provided by the Fed, money is drawn out of the financial system.  Conversely, when the Treasury cash balance declines, private sector liquidity goes up.  An easy way to see this is to equate a rise in the Treasury’s cash balance with more issuance in Treasury bills (which would be the necessary step for Treasury to grow its cash balance).  That incremental bill supply has to bought by someone, draining money from the private financial system.

When Treasury is faced with a debt ceiling impasse, it is legally required to trim its cash balance below the desired level.  All else equal, this infuses liquidity into the private financial system.  In 2019, the Fed continued to shrink its balance sheet throughout the period of time when the Treasury had to cut its cash holdings (see Exhibit 3).

Exhibit 3: Treasury cash balance in 2019

Source: Treasury Department, Bloomberg.

Then, when the debt ceiling stalemate in Washington was finally resolved in August, the Treasury ramped up its cash balance by $150 billion in a month.  That drained an equal amount from private sector liquidity in rapid fashion, precipitating the meltdown in the repo market.

Exhibit 4 shows the level of bank reserves plus RRP in 2019.  The rapid dip in this measure in August and September corresponds on an almost dollar-for-dollar basis with the rise in the Treasury’s cash balance.

Exhibit 4: Bank reserves plus RRP in 2019

Source: Federal Reserve.

I bring up this episode because the current debt ceiling suspension ends on January 1.  Thus, it is possible that, if Treasury is forced to draw down its cash balance substantially, the amount of liquidity in the private sector could be inflated in early 2025, potentially enticing the Fed to extract too much liquidity again, just as it did in 2019.  If the consensus view is correct that we would naturally reach the proper level of liquidity by the spring, the distortion caused by a debt ceiling impasse could obscure things again at a critical time, a risk that hopefully Fed officials and the New York Fed Markets Desk are well prepared for this time.