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The Fed May Have Shrunk Its Balance Sheet Too Quickly


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Federal Reserve Chair Jerome Powell. Photograph by Justin Sullivan/Getty Images
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777彩票地址Market conditions are forcing the Federal Reserve to revise its commitment to “normalizing” its balance sheet’s size.

The Fed has shed in bonds since October 2017. It now owns a bit more than $3.8 trillion in assets, against roughly $1.7 trillion , $1.6 trillion , and $500 billion in other liabilities, including some $250 billion owed to foreign central banks.

Spikes in overnight interest rates suggest the reduction may be overdone, and that more bank reserves may be required.

Shortly after finishing their second round of bond-buying in June 2011, America’s central bankers decided they the Fed’s balance sheet “to the smallest levels that would be consistent with the efficient implementation of monetary policy.” Over the next few years, additional purchases boosted total assets to nearly $4.5 trillion against about $1.2 trillion in currency, $2.8 trillion in bank reserves, and roughly $400 billion in other liabilities.

777彩票地址While economic impact was modest, the purchases were politically contentious. The Fed responded by reiterating its desire to shrink , declaring that it would “in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively.”

By itself, the statement was meaningless—how much is “necessary”?—but at the time, Fed officials thought this implied destroying in bank reserves over six years by shedding nearly $2.5 trillion in bonds. As the Fed’s then-boss in September 2014, the aim was “to get back to levels of reserve balances that we had before the crisis.” The assumption was that banks didn’t need the deposits they held at the Fed.

Yet bank reserves are uniquely useful for settling payments throughout the day and as a high-quality liquid asset that can . Rules imposed since the financial crisis have effectively transformed more than $1 trillion of “excess” reserves into required ones, according to a recent estimate by Credit Suisse’s Zoltan Pozsar. The “free float,” as he puts it, is extremely low, “with no margin of safety left.” That limits how much the Fed can shrink its balance sheet without destabilizing the banking system.

777彩票地址The Fed has gradually come to appreciate this. In its 2016 annual report, the Federal Reserve Bank of New York, which publishes regular projections of the balance sheet, assumed reserves would stabilize , rather than the previous forecast of $100 billion, although they described the adjustment as a way to capture “the uncertainty attending future levels of several Federal Reserve liability items,” rather than as a commentary on the appropriate level of bank reserves.

777彩票地址When the Fed balance-sheet reduction schedule in June 2017, the New York Fed estimated reserves would drop to as the balance sheet steadily shrank by $1.3 trillion until the middle of 2021. In a , Yellen said: “This is something that will just run quietly in the background over a number of years” that the Fed “will not be reconsidering from time to time.”

But market conditions have compelled Fed officials to reconsider. The biggest shift took place in January, when, of the central bank’s policy meeting, “almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings.”

777彩票地址As Jerome Powell, the current Fed chairman, stated that month: “If banks want to use reserves for a good and sufficient reason...we’re not going to discourage them from holding them.” In March, the Fed said it would of balance-sheet shrinkage, beginning in May, and completely stop it by the end of September.

The likeliest explanation, as Pozsar argues in detail, is that the decline in bank reserves has raised the cost of financing purchases of longer-term Treasury debt. From the perspective of a European or Japanese investor, the yield on a 10-year U.S. Treasury note has been far lower than the minimum hurdle rate since last fall.

According to Pozsar, this has “impeded the flow of collateral to ultimate buyers” and forced securities dealers to pick up the slack, while driving short-term interest rates higher.

The results can be seen in on securities dealers. Dealers have bought about $200 billion in Treasury debt since the U.S. yield curve effectively inverted last fall—and they have financed their purchases by increasing their overnight borrowing by a comparable amount. Those overnight collateralized loans, in turn, have mostly come from the big U.S. banks, as they replace their dwindling supply of reserves with other short-term assets. Heightened demand for overnight money has led in short-term interest rates since the end of 2018.

The system has become more fragile as a result of the Fed’s balance-sheet shrinkage. Pozsar thinks the Fed should be ready “to administer mini-QEs [quantitative easings]” before year-end to prevent turmoil. Powell may address this issue in his press conference this coming Wednesday.

Write to Matthew C. Klein at matthew.klein@barrons.com


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