Quantitative tightening has its limits: Don’t expect the US Fed to keep at it

Some advocate shrinking the balance sheet further for reasons ranging from reducing the Fed’s financial-market footprint to allowing more volatility in money market rates (in order to better monitor incipient market stresses) and enabling more rate cuts.

These advocates miss two points. First, that would not be an easy task, as it would require a dramatic change in how the Fed conducts monetary policy. Second, because a smaller balance sheet would not exert much restraint, it would not help lower short-term rates much.

The amount of reserves on the Fed’s balance sheet has shrunk sufficiently to reduce the level from ‘abundant,’ where supply always exceeds banks’ demand, to ‘ample,’ where demand can occasionally exceed supply, pushing up money market rates. As reserve conditions have tightened over the past two months, the federal funds rate has moved five basis points higher within its 25-basis-point target range. And repo rates have often risen above the rate available from the Fed’s standing repo facility (SRF), encouraging banks to borrow from it.

With its journey from abundant to ample complete, the Fed will cease shrinking its balance sheet and end quantitative tightening. Soon, it will begin to buy US Treasuries to ensure that the supply of reserves remains ‘ample’ rather than ‘scarce.’ This will offset the drain in reserves caused by the growth in demand for dollars and fulfil rising demand for reserves by banks.

The amount of currency outstanding has increased about 3% over the past year, and if that trend continues, it would require about $70 billion in Treasury purchases in 2026. If bank demand were to rise at a rate equal to nominal GDP growth (perhaps 4%), about $115 billion of purchases would be required. Together, the Fed’s total Treasury purchases would be less than $200 billion per year—a pittance relative to a $2 trillion annual budget deficit and outstanding Treasury debt held by the public of more than $30 trillion. Plus, the Fed would continue to roll over about $200 billion of mortgage-backed securities pre-payments into Treasury bills.

To shrink the balance sheet significantly further, the Fed would have to reduce demand for reserves by banks. To do this, it would need to make those reserves less attractive relative to other money market instruments. This is not straight-forward. When reserves shrink, repo rates rise and banks tap the SRF, which pushes the supply of reserves back up—negating any shrinkage of the Fed’s balance sheet.

To push banks out of reserves, the Fed would either have to raise the rate on the SRF or eliminate it altogether. As reserves shrink, money market rates (including Treasury bill rates) would rise. And once these rates climb sufficiently, banks would be induced to hold higher-yielding Treasury bills and other money market instruments rather than reserves. In the end, banks would hold less reserves and more Treasury bills and other money market instruments, while the Fed would hold fewer Treasuries.

One could engineer this outcome, but the transition would be difficult and the benefits modest, which is why Fed Chair Jerome Powell has endorsed the current ample-reserves regime. Banks would hold assets with less favourable attributes relative to reserves in terms of liquidity, ease of settlement and maturity. Money market rates would be more volatile and, with reserves scarce, banks would trade reserves among themselves, thereby increasing bank counterparty risk.

The only meaningful benefit would be that banks would no longer get a preferential rate on reserves relative to the rate available on Treasury bills and repos, and the Fed would no longer hold Treasury bills at rates slightly below the rate it paid on its reserves.

This subsidy is modest, with interest rate paid on reserves at 4% and the four-week Treasury bill rate at 3.95%. Yet, it overstates the subsidy because the current four-week bill yield incorporates about a 80% probability that the Fed will cut rates by 25 basis points this month.

Pushing banks out of reserves into Treasury bills would save the Fed (and by extension the US government) only about four to five basis points in my estimation.

After all this gymnastics, a smaller Fed balance sheet would exert little monetary policy restraint as its stance would still be determined by the level of short-term rates, not the size of the Fed’s balance sheet. In short, further shrinkage of the Fed’s balance sheet would not enable much lower short-term rates. ©Bloomberg

The author is a Bloomberg Opinion columnist.