The new indicator from the Federal Reserve gives the green light: QT can still continue to advance!

A new indicator introduced by the New York Fed on Thursday shows that the Federal Reserve is not facing an imminent market liquidity challenge, thus unable to prevent the continued contraction of its balance sheet.

This new indicator, called Reserve Demand Elasticity (RDE) by the New York Fed, aims to measure the liquidity of bank reserves. The Fed stated that this will help Fed officials better manage the uncertain process of reducing bond holdings, known as Quantitative Tightening (QT).

The purpose of establishing the new indicator is to serve as an early warning indicator for bank reserve shortages. The New York Fed stated in a blog post that this indicator will help identify the transition point from abundant liquidity to a "sufficient" level. Policymakers often find it difficult to determine the "sufficient" reserve level.

As of data available as of October 11th, the indicator indicates that "reserves remain ample." The latest estimate of RDE is close to zero, indicating that the federal funds rate will not significantly respond to changes in reserve supply. For reference, a negative reading of RDE would indicate a tightening of liquidity.

The Fed's QT process has been ongoing for over two years, shrinking its balance sheet from a peak of $9 trillion to the current level of $7.1 trillion. Post the COVID-19 pandemic, the Fed is seeking to withdraw unnecessary liquidity as part of monetary policy normalization.

The Fed aims to ensure there is enough liquidity in the financial system to firmly control the federal funds rate, which is the primary monetary policy tool through which the Fed influences the economy. However, officials face the challenge of not knowing when liquidity may become too scarce, leading to volatility in money market rates.

Earlier this year, the Fed slowed down the pace of QT to more easily identify any imminent liquidity challenges before they arise. This is because officials were wary of the turmoil caused by the previous QT, when liquidity unexpectedly tightened in September 2019, prompting Fed intervention to increase market liquidity.

Fed officials stated that they expect the QT plan to continue for some time. Prior to the Fed's September policy meeting, market participants anticipated this process to end in the spring.

By the end of September before entering the fourth quarter, the volatility in the money markets was enough to make some market participants speculate that the Fed might need to end QT early. However, St. Louis Fed President Bullard pointed out in comments on October 7th that the federal funds rate has been "well controlled" for some time, implying that recent fluctuations will not affect the outlook for QT.

So far, the Fed's QT process has mainly involved draining cash from reverse repo tools. The Fed's usage of reverse repo tools has significantly decreased this year.

Changes in the Fed's balance sheet size The Fed's QT mainly extracts liquidity from reverse repurchase tools.

At the same time, the collective reserve level of banks has remained almost unchanged for a long time. Most observers believe that the Fed will be able to continue implementing QT before they start to decline.

Bank reserves remain stable.

In a blog post, the New York Fed pointed out that the RDE was negative well before the trouble in September 2019, indicating that the new indicator can help officials anticipate when reserve shortages may occur, challenging their control over the federal funds rate.

Prior to the publication of the above article by the New York Fed, analysts at investment bank Barclays Bank stated, "We expect bank reserves to remain slightly above the 'adequate' threshold by the end of the year." They continue to expect the Fed's QT to end this year, ahead of the expectations of many other traders and investors.

The New York Fed stated that it will update the reading of RDE at 10 a.m. on the third Thursday of each month in Eastern Time, except for Federal Open Market Committee (FOMC) meeting dates