The Fed's big test: Shrink its balance sheet without shocking banks

The Federal Reserve wants its balance sheet runoff to continue as long as possible, but doing so could mean persuading banks to hold fewer reserves. 

A sudden spike in reserve demand brought the last round of quantitative tightening to an early end in 2019 and ultimately caused the Fed to grow its balance sheet again. The central bank learned from that episode and took steps to prevent it from repeating. But this time around it faces a new complication: elevated reserve demand in the wake of last year's banking crisis.

"Everybody is cognizant of what's happened in the past year and a half with respect to liquidity and the dangers associated with not having the available liquidity when necessary," said John Buran, president and CEO of Queens, New York-based Flushing Bank.

Regulation and compliance

The hidden dangers in the Fed's balance-sheet reduction

October 11, 2022 9:00 PM

For more than two years, the Federal Reserve's balance sheet reduction has quietly shrunk the central bank's holdings by nearly $2 trillion. Now the process is beginning to take center stage, with multiple speeches from Fed officials about the asset runoff this past month and the launch of a new instrument to track the demand of reserves, billed as an early warning tool for scarcity.

The remarks and the data all point to the same conclusion: the level of reserves in the banking system remains abundant, above the ample range that the Fed targets and well clear of the scarce territory that could strain liquidity and disrupt the transmission of monetary policy.

Angelos Manolatos, a macro strategist for Wells Fargo, said the Fed is signaling a desire to shrink its balance sheet as much as possible.

"Everything from the Fed is telling me they want to do QT a little bit longer, they want to make the balance sheet smaller and, potentially, shorter in duration by shifting more toward [Treasury] bills," Manolatos said. "Because of the interplay between QT and reserves, it tells you that the Fed wants to do more QT and wants a stricter balance sheet with less reserves in the system, and they're trying to make some changes in order to accomplish that."

One of those adjustments came in the form of a clarification to the Fed's regulation on internal liquidity stress testing. In a note published on its website, the agency advises banks that they can include borrowings from the Fed and advances from Federal Home Loan Banks in their liquidity plans. 

Knowing this, banks can feel less reliant upon reserves to cover all of their liquidity needs, Fed Vice Chair for Supervision Michael Barr said in a late September speech.

"When firms understand that they will not be fully constrained by the capacity of private markets or their individual credit lines to monetize [high-quality liquid assets] immediately in stress, they can reduce their demand for reserves in favor of Treasury securities, all else being equal, for their stress-planning purposes," Barr said. "This dynamic improves the substitutability of holding reserves and holding Treasury securities either outright or through [repurchase agreement] transactions."

The comments and the clarification come as part of Barr's push to encourage banks to incorporate the Fed's discount window lending facility into their liquidity plans. The Fed's chief regulator said greater substitutability of reserves and other high-quality assets should prevent pockets of scarcity from forming when the overall supply of reserves is ample.

"When banks can nimbly adjust portfolios in response to price incentives, the efficiency of reserves redistribution through the system improves, and market functioning is enhanced," Barr said.

Derek Tang, co-founder of the Washington, D.C.-based research firm Monetary Policy Analytics, sees Barr's comments and the Fed's new internal liquidity stress testing guidance as an attempt to dissuade banks from stockpiling reserves.

"The logic behind that is: if banks can be comfortable knowing that the discount window is there, and they are going to be able to use it whenever they want, maybe they don't need to hoard reserves in advance," Tang said. 

Supply and demand

Banks only need enough reserves — funds held at the central bank — to meet regulatory minimums and settle day-to-day transactions, but most maintain holdings at the Fed in excess of that, either out of their own sense of precaution or at the encouragement of their examiners. 

From December 2021 through February 2023, reserves fell steadily from roughly $4.2 trillion to $3 trillion, with dropoff accelerating after the announcement of QT in March 2022. But that trend reversed in March 2023 when the level of reserves jumped back up above $3.2 trillion after the failures of Silicon Valley Bank and Signature Bank. The level remains above that mark today.

Reserves are one of several categories of liabilities on the Fed's balance sheet along with currency in circulation, the Treasury's general account and the central bank's various repurchase agreement, or repo, facilities. As the Fed sheds assets, namely Treasuries and mortgage-backed securities, its liabilities must fall in lockstep.

Bill Nelson, chief economist for the Bank Policy Institute and a former Fed monetary affairs official, said there is no prescribed ideal size for a central bank's balance sheet, but the Fed has several motivations for reducing its holdings.

"They would like the balance sheet to be as small as it can be without actively managing it on a daily basis," Nelson said. "They want to demonstrate that [quantitative easing] can be reversed, they have concerns about the political economy of making large interest payments on reserves and they are concerned, to some extent, about their overall footprint in the financial market."

Most of the Fed's roughly $2 trillion of balance sheet runoff has been offset by declines in the overnight reverse repo, or ON RRP, facility, an outcome broadly expected by Fed officials and outside economists alike. Yet, while usage of the facility has declined substantially from its $2.2 trillion peak last spring, the rate of decline has tapered in recent months, raising questions about whether the program's usage will return to near-zero levels.

In a speech this week, Federal Reserve Bank of Dallas President Lorie Logan said the remaining ON RRP users are "stickier" than those moved out earlier in the QT process. She argued that "meaningful ON RRP balances should not form a permanent fixture on the Fed's balance sheet," and said it might be appropriate to drop the facility's interest rate to incentivize participants to move elsewhere. 

On reserves, Logan said while banks' baseline level of demand for them has increased above its pre-pandemic level, she believes the system could tolerate a smaller volume of reserves than what currently sits on the Fed's balance sheet.

"Reserve balances are around $3.2 trillion, compared with around $1.7 trillion in early 2020," she said. "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."

Early warning signs

Still, some recent market activity indicates that financial market liquidity is becoming less abundant. 

At the end of last month, the secured overnight financing rate, or SOFR, and various repo market rates rose significantly above the Fed's interest on reserve balance, or IORB, rate. While it is common for repo activity to pick up at the end of quarters as firms look to clean up their books for reporting purposes, analysts say this was the largest spike seen since 2018 and could be a potential early warning sign of declining liquidity.

"Compared to previous quarter-end moments, this was significantly more pronounced," Tang said. "It doesn't mean that reserves are at a scarce stage, but it could mean they're less ample and moving towards the adequate stage, where there are enough reserves in the system for normal times, but at quarter-end or even month-end events you see some strain occur."

Because the demand for reserves can vary widely from institution to institution as well as across the banking sector in times of stress, the Fed does not have a set target for reserve supply. Instead, the loose measurement terms are scarce, ample and abundant. Still, even determining where reserve supply falls on that spectrum can be a fraught exercise, Roberto Perli, manager of the Fed's System Open Market Account, or SOMA, said in a recent speech.

"It is very difficult, if not impossible, to quantify the level of reserves associated with an ample reserves regime with a high degree of certainty," Perli said. "Because reserve demand is influenced by a mix of factors and can change over time, a better strategy to assess reserve conditions, in my view, is to monitor a variety of signs embedded in market prices and quantities."

One way to do this, Perli said, is to compare the spread between the effective federal funds rate — what banks charge one another for overnight borrowing — and the IORB rate. When reserves become scarce, the federal funds rate increases relative to the interest paid on reserves. 

This data set is the basis for the Federal Reserve Bank of New York's Reserve Demand Elasticity measure, which was launched last week. The online tool is designed to indicate when the demand curve for reserves is beginning to slope, indicating less abundance. 

According to the measure, the demand curve for reserves has been "flat" since late 2020, even as the total supply of reserves has fallen by nearly a trillion since its peak in 2021. The New York Fed noted that the chart should turn negative well in advance of reserves becoming scarce.

The new tool is viewed as a positive development among market participants and analysts, as it provides transparency into how the Fed is thinking about the reserve supply. But, some are skeptical that the measure will help the central bank hit the optimal level of reserves.

"The Fed is trying to find a stable level of reserves where demand is sloping up slightly, but I think it will be much more complicated than that," BPI's Nelson said. "It will be more messy."