By Michael S. Derby
NEW YORK (Reuters) – The Federal Reserve, which wraps up its latest monetary policy meeting on Wednesday, is about to enter one of the more challenging periods of managing what most observers believe is the approaching endgame for its balance sheet drawdown.
That’s because even as the Fed is expected in coming months to get financial sector liquidity down to levels that will allow it to stop rolling off expiring Treasury and mortgage bonds from its balance sheet, it will be hard to try to get a handle on how tight liquidity is.
Why? The U.S. government debt ceiling is again an issue and until that’s resolved and borrowing can rise, the current cap will affect Treasury bond issuance in a way that will obscure already difficult efforts to gauge money market liquidity.
The Fed, since 2022, has been allowing bonds to run off and not be replaced in an effort called quantitative tightening, or QT. That’s lowered U.S. central bank holdings from a peak of about $9 trillion to the current mark of $6.9 trillion. The Fed is aiming to pull out excessive liquidity to allow for ongoing firm control of the federal funds rate, its primary tool to influence the economy’s momentum, and permit normal levels of money market volatility.
Fed officials are also seeking to avoid the tumult seen in markets in September 2019 when the previous version of QT unexpectedly hit the wall and forced the central bank to start adding liquidity back into markets. To ward off a replay, Fed officials have already slowed the pace of QT, adopted new tools for fast liquidity provision, and created new public ways to measure market liquidity.
Even without the government debt management issues, eyeing the QT stopping point was hard, but now it gets harder. The minutes from the Fed’s Dec. 17-18 meeting warned “the potential reinstatement of the debt limit in 2025 could result in substantial shifts in Federal Reserve liabilities that could pose challenges in assessing reserve conditions.”
The document also said that debt ceiling machinations could affect another proxy for market liquidity, the Fed’s reverse repo facility. That tool, which allows money funds and other institutions to park cash at the central bank, has been draining for some time. But with fewer Treasury bills on the market due to government borrowing management, financial firms could move cash back into the reverse repo facility, obscuring the market liquidity signal it has so far provided.
‘SUBSTANTIAL SHIFTS’
Private sector forecasters are still on board with the Fed’s December QT assessment. “The potential reinstatement of the debt limit in 2025 could result in substantial shifts in Federal Reserve liabilities that could pose challenges in assessing reserve conditions,” analysts at LH Meyer said.
As it now stands, Fed observers do not expect the QT outlook to be an issue for the two-day policy meeting that ends on Wednesday and it’s possible it won’t even be tackled by Fed Chair Jerome Powell in his post-meeting press conference, given more pressing economic issues.
The most recent guidance on QT came from New York Fed President John Williams, who told reporters earlier this month that he has “not seen any particular signs” reserves had become tight enough to stop QT. He also said “I don’t have a prediction” of when QT will wrap up.
Ahead of the Fed’s meeting last month, big financial institutions had pushed back to June the end point for QT, but some banks think the Fed may have even more room to run. Greater clarity on that outlook could arrive once the U.S. government’s debt management has been squared up.
(Reporting by Michael S. Derby; Editing by Paul Simao)
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