From June 2022, to curb rising inflation, along with the higher-for-longer interest rate policy, the Fed began gradually reducing its balance sheet by selling MBS or stopping reinvestment of maturing bonds (QT).
As of last Wednesday, the Fed has reduced its assets from a peak of nearly USD 8.96 trillion to USD 7.48 trillion. However, at an appropriate time, the Fed will have to stop QT, or even reverse the impact of the previous QT policy.
In previous articles, Viet Hustler has analyzed in detail multiple times the possibility of Fed rate cuts in the near future. Therefore, this week's Macroeconomic article from Viet Hustler will analyze the Fed's second macroeconomic regulation tool: monetary policy. And among them, an equally important question as to whether the Fed will cut rates is: When will the Fed stop QT?
And the best way for the Fed to choose the time to stop QT is to look at the amount of cash that commercial banks are reserving at the "Federal Reserve" itself (the Fed).
The parallelism between monetary policy and commercial banks' cash reserves (reserves) at the Fed
In recent policy planning statements, the Fed has always emphasized:
"Over time, the Committee intends to maintain holdings of securities in the amount necessary to conduct monetary policy effectively and efficiently in its ample reserve regime"
So what are the "ample" reserve regimes (ample reserve regime) or scarce (scarce reserve regime) here?
The Fed's main lever to guide the economy is through adjusting short-term interest rates - especially the Fed funds rate.
The Fed funds rate is the benchmark for interbank loans (overnight bank funding rate), ultra-short-term loans (secured overnight financing rate) and also the standard for other short-term interest rates.
Before the 2008 global financial crisis:
The Fed used bank reserve ratios at the Fed (bank reserve) to influence the actual Fed funds rate (Fed funds effective rate).
At that time, the Fed's goal was "scarce reserve regime" (scarce reserves regime):
Banks held as few reserves as possible, partly because at that time the Fed did not pay interest on those deposits.
And the Fed also encouraged banks to lend to businesses to promote economic growth.
FYI: At that time, the Fed managed the amount of cash reserves by buying and selling short-term Treasury bills (T-bill) daily as follows:
The Fed buys T-bills and pays the seller by check with funds drawn from the bank's reserves (which is the Fed's debt to the bank).
The bond seller deposits that check into their commercial bank, returning liquidity to the banking system.
The bank can lend that money or deposit reserves at the Fed - increasing reserves at the Fed.
Therefore, at that time, the Fed buying T-bills/T-bonds/MBS or other assets would create liquidity for banks. T-bills would have more impact on short-term yields.
(When the Fed sells those securities later during QT phases, the process reverses - bank liquidity decreases.)
An increase in cash reserves at the Fed (reserve supply/deposits at the Fed) pushes down the federal funds rate (price of reserves/yield on deposits at the Fed) and other interest rates,
While a decrease in the reserve supply at the Fed increases interest rates (because the Fed also has fewer reserves as collateral to write checks to sell T-bonds/bills => money supply decreases).
However, the 2008 Global Financial Crisis (GFC) followed by the subsequent Great Recession changed everything:
At that time, the Fed struggled to fight the recession by pushing short-term interest rates down to ~0% but it was still not enough to revive the economy (liquidity trap).
The Fed bought large quantities of T-bonds and MBS (QE) with the goal of pushing long-term interest rates (still above 0%) down.
Reducing long-term interest rates at that time was very important because it directly affects mortgage rates and corporate borrowing rates.
When the Fed buys long-term bonds, it naturally creates a large amount of bank reserves:
Banks receive cash from the Fed after selling securities and deposit most of it back at the Fed…
The Fed also needed banks to increase cash reserves to use that money to execute QE.
(From a balance sheet perspective, Fed assets, i.e., bonds bought by the Fed, must equal liabilities, i.e., consisting of bank deposits:
Assets increase (QE) ~ increase in liabilities, mainly reserves and currency.
Assets shrink (QT) ~ decrease in liabilities.)
Along with implementing QE since 2008/2009, the Fed shifted to the goal of the "ample cash reserves regime" (ample reserves regime) increasing the amount of reserves held by banks at the Fed:
Banks were willing to deposit more money because the Fed began paying interest on reserves exceeding the required reserve ratio under BASEL I (and later BASEL II) - Excess Reserves.
These interest payments were later called Interest on Excess Reserve Rates (IOER).
At that time, the reserve ratio of banks' funding at the Fed increased from 8% (minimum reserve level) to ~19%.
The shift to abundant reserves and the Fed's interest payments changed the way the Fed controls short-term interest rates:
The Fed no longer influences the federal funds rate (Fed fund effective rate) by injecting or withdrawing reserves daily.
Instead, the Fed directly adjusts short-term interest rates through the interest rate paid on banks' Excess Reserves deposits.
As long as the Fed keeps short-term interest rates at 0%, the financial system will continue to increase cash reserves at the Fed, and the Fed can still control short-term interest rates through the IOER rate.
But in 2015, when the reserve ratio became excessively abundant, the Fed wanted to start raising short-term interest rates in the free market using open market operations:
From late 2014 - early 2015, the Fed purchased overnight Reverse Repos to raise short-term interest rates (part of the QT policy on short-term rates).
Since 2018, the Fed has implemented QT on long-term rates by selling 30 billion USD T-bonds and 20 billion USD MBS per month, only slowing the QT process one year later - in 2019.
But at the time the Fed slowed QT in 2019, market pressures gradually became apparent:
The government's sudden increase in borrowing at that time (causing banks to withdraw reserves to buy T-bonds) + banks/companies withdrawing money to pay taxes created a severe shortage of cash reserves at the Fed in September 2019.
The result was:
Interbank market rates (overnight bank funding rate) rose beyond the Fed's target range.
Short-term rates in the free market (SOFR) also spiked more than 3x.
All explained by the scarcity of cash reserves at the Fed in 2019 - the result the Fed faced when implementing QT from 2015-2019:
At that time, bank reserves fell to about 1.5 trillion USD: touching the minimum required reserve level (8%)
To fix the problem, the Fed began promoting higher bank reserves through a generous short-term QE policy from 2019-2021 (especially during Covid) to stimulate growth.
Causing the cash reserve ratio at the Fed to rise again to an excessively abundant level, peaking in 2021.
What different impact does this QT cycle have on banks' cash reserve ratio at the Fed?
The recent Fed QT cycle is also causing banks' cash reserve ratio at the Fed to decline.
But what's special is that the decline rate of the cash reserve ratio at the Fed is somewhat slower than the 2015-2019 period.
In fact, cash reserves even increased from the second half of 2022.
The reason may be changes in the required reserve ratio regulations for banks at the Fed under BASEL III.
However, a large part of the reason also comes from the Fed's BTFP program, which directly lends to banks at extremely low rates – so they deposit at the Fed at higher rates.
But also because cash reserves have not yet fallen to normal levels, the Fed is not rushing to stop QT! Especially when inflation is still around 3% y/y.
So when is the appropriate time for the Fed to stop QT?
Currently, the Fed maintains the QT pace at selling 95 billion USD T-bonds and MBS per month.
After the March FOMC, Powell said the Fed is considering slowing QT to “help ensure a smooth transition, reducing the likelihood of money market stress”.
That is: The Fed will gradually slow QT to observe the market, where the measure for the money market (short-term lending rate market) is the cash reserve ratio at the Fed!
The logic behind the Fed observing reserve levels to decide on QT or stopping QT is that: reserve levels indicate the liquidity condition of the banking systemMeanwhile, the total reserve balances of the banking system at the Fed are at the level of
If banks face a severe cash shortage (credit crunch) for more profitable lending activities (business loan rates are usually higher than Fed deposit rates), they will naturally withdraw excess reserves (Excess Reserves) at the Fed and only keep required reserves.
But if they still have enough cash for normal operations - or excess cash, they will keep the money at the Fed to earn safe interest rates.
The gradual reduction of reverse repos is a move to slowly stop “QT”.
However, RRP contracts only affect short-term rates.
To lower long-term borrowing rates, the Fed still needs to stop buying MBS, T-bonds, and other financial assets…
And the Fed will not rush to cut long-term rates, simply because total market liquidity is still quite high: partly making inflation hard to reduce.
In particular, the current cash reserves of depository institutions at the Fed are still at the level of 3.5 trillion USD
… a quite “abundant” level compared to the scarcity situation in 2019 - despite the recent interest rate hiking cycle and QT by the Fed.
(Reasons as mentioned above: due to BTFP and BASEL III)
The Fed will have to balance the appropriate timing to stop QT: ensuring bank cash reserves are not too abundant (abundant) and not too scarce (scarce):
Banks holding too much cash can also limit the maximum capacity of lending activities.
On the other hand, if cash reserves are too low, it risks causing overnight interbank market rates to spike sharply as in September 2019.
However, what balance level ensures an ample reserves regime when the currency has lost value after a long period of inflation?
The first approach is through the bank's reserve ratio based on their total asset value.
BASEL III requires:
mandatory reserve ratio 10.5% total asset value at Tier 1 + 2 level.
up to 13% (additional +2.5%) to protect against countercyclical macro risks as at present.
And up to 15.5% for groups of banks with global systemic importance (G-SIB) - but only a few banks belong to this group (29 G-SIB banks out of total 4614 banks in the US).
Viet Hustler speculates that the average mandatory capital reserve ratio (according to BASEL III) for the entire US banking system will fall into the range of 13.0% - 13.6%Meanwhile, the total reserve balances of the banking system at the Fed are at the level of
Currently, the bank's capital reserve ratio is up to 15.06% total assets.
However, the cash reserve ratio of the banking system is used to protect the entire economy.
Many studies indicate that reserve amounts should be calculated based on the country's GDP:
St. Louis Fed study (Estenssoro & L. Kliesen, 2023) proposes reserve levels of 10% - 12% nominal GDP: equivalent to According to the research of Fred St. Louis, the ample reserve level should fall into the range ofMeanwhile, the total reserve balances of the banking system at the Fed are at the level of
Fed Waller, speaking at the Hutchins Center in January 2024, gives the figure of 10% - 11% nominal GDP: equivalent to USD 2.8 - 3.03 trillionMeanwhile, the total reserve balances of the banking system at the Fed are at the level of
(Nominal GDP data calculated at the end of 2023: USD 27,956.998 trillion)
Meanwhile, the amount of reserves of the banking system at the Fed is . - still some distance from the two upper limits.
CONCLUSION
The Fed's plan to stop QT is still quite vague after the March FOMC and statements from Fed officials. However, the slow pace in stopping QT, especially regarding the Fed's sale of long-term assets, is completely justified.
Because the QT cap set by the Fed is partly based on the credit crunch situation in the financial market.
In which, the amount of capital reserves that the banking system deposits at the Fed is one of the tools for the Fed to observe capital market dynamics and market liquidity.
The Fed will certainly not maintain QT too long so that reserves decline causing a credit crunch in the interbank market like in September 2019.
Nevertheless, the Fed still has no incentive to stop QT if inflation remains high and the reserve balances of the banking system at the Fed are still quite high compared to the average level.
According to Viet Hustler's estimate, the required reserve balances under BASEL III at the Fed in the worst macroeconomic conditions would only be at the level of: 13.0% - 13.6% of the total asset value of the US banking system. Meanwhile, currently, the reserve ratio is up to 15.06%Meanwhile, the total reserve balances of the banking system at the Fed are at the level of
According to Waller, the currently appropriate ample reserve level is equivalent to USD 2.8 - 3.03 trillion. According to the research of Fred St. Louis, the ample reserve level should fall into the range ofUSD 2.8 - 3.35 trillion .Meanwhile, the total reserve balances of the banking system at the Fed are at the level of
USD 3.496 trillion
.
Therefore, no matter which calculation method is used, the reserve balances at the Fed are still in the ample zone, and have not yet reached the alarming level for the Fed to begin stopping QT.
The Fed's current gradual (and slow) reduction of QT is fully justified. ReferencesAmalia Estenssoro and Kevin L. Kliesen, "The Mechanics of Fed Balance Sheet Normalization,"
Economic Synopses
, No. 18, 2023. https://doi.org/10.20955/es.2023.18 David Wessel, “How will the Federal Reserve decide when to end “quantitative tightening?”, Brookings Institution, 2024.Gara Afonso, Gabriele La Spada, and John C. Williams, “Measuring the Ampleness of Reserves,” Federal Reserve Bank of New York
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