By Jonnelle Marte

(Reuters) – As the Federal Reserve prepares to reduce its bond holdings faster and more quickly than ever before, officials claim a new tool combined with lessons learned from the past should smoothen the process and prevent market turmoil that was caused by its previous efforts.

Fed leaders must be careful as they work out the best way to shrink their portfolio of $9 trillion. Some analysts suggest that this will require them to use more aggressive strategies than before. It’s a critical question facing the Fed as it looks to right-size https://www.reuters.com/markets/us/fed-signals-readiness-shrink-balance-sheet-why-thats-big-deal-2022-01-06 its asset holdings, which roughly doubled in less than two years as it amassed Treasuries and mortgage-backed securities to help lower borrowing costs and cushion the economy and markets from the coronavirus pandemic.

Officials claim that no more support is needed, with inflation at its highest point and unemployment returning to pre-pandemic levels. But it is unclear how small the balance sheet will get https://graphics.reuters.com/USA-FED/BALANCESHEET/byprjmwezpe/index.html. To see if the balance sheet is shrinking, officials will need to closely monitor the markets and economies to determine if it’s too much.

What could go wrong?

Officials tried to decrease their bond holdings last year, but only managed to shrink it by 15% before running into problems. That was because the level of reserves, or deposits that banks hold with the Fed, got too low, which led to a spike in short-term borrowing costs in September 2019 https://www.federalreserve.gov/econres/notes/feds-notes/what-happened-in-money-markets-in-september-2019-20200227.htm.

The ambitions of officials this time are higher. Many see a lower level than before the start of the global healthcare crisis in early 2020, which would mean a decrease of more than half. Some economists doubt that the Fed will reach this level, and if so, if they can lower it due to existing central bank facilities.

NEW TOOL COULD HELP

A new tool set up last year, known as the standing repo facility https://www.reuters.com/article/us-usa-fed-standing-repo/fed-establishes-standing-repo-facilities-to-support-money-markets-idUSKBN2EY2OS, can serve as a backstop for banks in need of cash and may help to prevent another surge in short-term rates. The facility could be used to borrow by financial institutions if their reserves are low.

Economists and analysts agree it is only possible if banks aren’t criticized for turning towards the Fed to get temporary cash loans. Bill Nelson, the Bank Policy Institute chief economist, and a former Fed economist, said that the program is similar to the Discount Window, an established emergency lending facility many banks have resisted using because they fear being viewed as at risk.

Nelson stated that some companies should be more comfortable with Treasury securities now that the SRF is in place. They can convert these Treasury securities to cash “if necessary”. However, that is dependent on the Fed stating that this facility should be used as a normal course of business.  

EXTRA CASH FOR ‘SLOSHING’ AROUND

The popularity of a Fed tool which lets banks store their cash overnight has led to financial institutions dealing with excess cash for the past year. The reverse repo program has seen an average of $1.5 trillion in use over the past 3 months.

According to Tiffany Wilding (a PIMCO economist, and an ex-analyst at the New York Fed), this suggests the Fed may be able to cut its balance sheet at least by that amount. “There’s more money sloshing around in the system now than banks want,” Wilding said. The Fed may shrink its reserves, which could mean that reverse repo usage will not drop immediately, Nelson said. Therefore, officials must be cautious.

WILL THE FED BE REQUIRED TO SELL BONDS EXCLUSIVELY?

This is a huge unknown. Fed officials aren’t ruling out anything, but they have generally avoided discussing actively selling assets. Instead, passively letting the bonds mature, the Fed would allow the portfolio to be reduced. However, it’s unclear if the Fed will be able to reduce its holdings at the pace that some want.

Some analysts, like Zoltan Pozsar at Credit Suisse (SIX:), argue that the Fed may be pressed into bond sales https://www.reuters.com/business/finance/fed-could-resort-outright-asset-sales-reduce-balance-sheet-credit-suisse-2022-01-24 this time because of the size of the inflation threat, the run-up in risky assets during the Fed’s quantitative easing phase and a flattening Treasury yield curve.

Pozsar said that it was not unlikely for an asset to be sold if there is inflation, excess, or a curve change.

HOW WILL THEY KNOW IF THEY HAVE GOEN TOO LOSE?

It is possible that the balance sheets from before the pandemic were not a reliable indicator of how low they can go this time. One factor is that “banks’ demand for reserves varies over time,” Lorie Logan, an executive vice president in the Markets Group of the New York Fed, said earlier this month during an interview https://www.mercatus.org/bridge/podcasts/01102022/lorie-logan-monetary-policy-operations-fed%E2%80%99s-new-standing-repo-facility-and with the Macro Musings podcast.

Logan stated that the Fed will monitor money markets to determine if reserve levels are too low. As she and other New York Fed officials explained in a recent blog post https://libertystreeteconomics.newyorkfed.org/2022/01/how-the-fed-adjusts-the-fed-funds-rate-within-its-target-range, the relationship between the effective federal funds rate (EFFR), or the Fed’s main target rate, and the interest rate that the Fed pays on reserve balances (IORB) is important.

When reserves are plentiful, the rates trade farther apart. This was true between 2013-2014. The rates are closer to each other when reserves balances decline, like they were in 2013 and 2014.