As the Federal Reserve attempts to rightsize its balance sheet, one top reserve bank official said there are risks in both staying too big and becoming too small.
Federal Reserve Bank of Cleveland President Beth Hammack, in a Wednesday night speech, said keeping the balance sheet too large incentivizes risk taking in the private sector, while shedding too many assets from the Fed's books could create volatility in the overnight reverse repurchase agreement market and the money market mutual funds that operate in it.
But, Hammack said, a little
"Some volatility in overnight markets may not be such a wild thing," Hammack said in a speech riddled with references to the Cleveland-based baseball comedy Major League. "It could help inform market dynamics and provide additional discipline to the market, giving firms practice and incentive to prepare for the occasional large move."
Still, even if the Fed does adopt a greater tolerance of money market movement, Hammack said there are open questions about "how much and what type of volatility is acceptable?"
During her remarks, delivered in front of the Money Marketeers of New York University, Hammack delved into the nuances of both the Fed's balance sheet and its years-long effort to reduce its size.
The Fed began shrinking its balance sheet in June 2022 by allowing matured securities to roll off its books without being replaced up to a certain cap. Since then, the central bank has reduced its holdings by $2.2 trillion.
Hammack said she would have liked to have seen the Fed continue allowing $25 billion of Treasuries to roll off its books this month rather than
"With reserves still abundant, I believe that runoff could have continued at the prior pace for the time being rather than slowing as we did at our March FOMC meeting," she said. "However, I supported the decision to slow the pace as a necessary next step in the process to approach the 'just-above-ample' point carefully."
As it reduces its assets, the Fed must also shrink its liabilities by a commensurate amount. Thus far, that reduction has come primarily from its overnight repo borrowing program, but with that facility nearing zero, quantitative tightening, or QT, will soon begin
Hammack said the Fed's goal is to lower the amount of reserves from the current level, deemed "abundant," to one that is merely "ample," or sufficient to cover bank liquidity requirements and enable the financial system to function normally.
"If reserves fall below the quantity consistent with an ample regime, then small fluctuations in the supply of and demand for reserves could increase volatility in overnight money markets, potentially dramatically," she said. "And if the supply of reserves falls far below those in an ample regime, then the funds rate could rise above the top of the target range. In fact, we saw this in September 2019."
Hammack said determining the optimal size of the balance sheet is something the FOMC will deliberate over as it looks to bring QT to an end. But, she said she takes the decision to slow runoff last month as a signal that the committee wants the process to continue as long as possible.
More than others on the committee, Hammack said, she is focused on the risks of having a bigger balance sheet than is absolutely necessary.
"To the extent that a large balance sheet with more-than-ample reserves dampens money market volatility, it also promotes risk-taking in financial markets," she said. "We have seen this with the increase in hedge fund basis trading and invoice spreads, a trend worth watching and one I've noted elsewhere."
To counteract distributive scarcity, in which some banks have access to ample reserves but others do not, Hammack said the Fed should consider steps like mandatory testing of firms' abilities to use the Standing Repo Facility, which acts as a backstop for money markets to ensure there is sufficient liquidity in the financial system during times of stress. She added that central clearing of SRF transactions could also help destigmatize the facility.
Overall, Hammack said she is comfortable with slightly more frequent Fed interventions into the financial space if it can be done without expanding its balance sheet.
"In general, if a scarce-reserves regime requires regular intervention in the market and an abundant-reserves regime requires no intervention, then an ample-reserves regime that requires occasional intervention strikes me as about right," she said. "This may be an area worthy of discussion by the FOMC."
