Cutting interest rates while shrinking the balance sheet, what does the Fed intend to do?

According to the Wise Finance APP, while people are focusing on the interest rate actions that the Federal Reserve may take in 2024 and beyond, another policy area, although dull, is equally important. This policy area is the ongoing reduction of the Federal Reserve's balance sheet, known as quantitative tightening.

Although the Federal Reserve seems to have contradictory policies by loosening policy through interest rate cuts on one hand and tightening policy through balance sheet reduction on the other, the current status of the Federal Reserve's balance sheet has not brought significant news, which is good news for the market.

The Federal Reserve's balance sheet is crucial for the execution of its monetary policy. Banks hold reserves with the Federal Reserve and earn risk-free returns, effectively setting a floor for interest rates in the entire financial system. Through this mechanism, the Federal Reserve guides the federal funds rate - its main benchmark rate, which it lowered to a target range of 4.75% to 5% in September. In addition, banks and other financial institutions can lend their holdings of U.S. Treasury bonds to the Federal Reserve through repurchase agreements (repo) to obtain cash to meet liquidity needs.

During financial crises or periods of stress, the Federal Reserve can quickly inject cash into the economy through its balance sheet to maintain credit flow. During the COVID-19 pandemic, the Federal Reserve took massive actions, expanding its balance sheet from around $4.2 trillion in early 2020 to nearly $9 trillion at its peak in 2022, when the Federal Reserve purchased a large amount of U.S. Treasury bonds and mortgage-backed securities.

Since March 2022, the Federal Reserve has been reducing its balance sheet, with its size decreasing to $7 trillion as of last week. Federal Reserve officials slowed down this process in June. Currently, the Federal Reserve allows a maximum of $250 billion in U.S. Treasury bonds and $350 billion in mortgage-backed securities to mature each month without reinvesting their proceeds.

By allowing these securities to mature naturally without reinvestment, the Federal Reserve gradually reduces bank reserves, meaning less cash available for lending by banks, which could potentially put upward pressure on bond yields.

This seems contradictory to the Federal Reserve's interest rate cuts. San Francisco Fed President Daly explained this contradiction as a matter of timing. She said at an event at New York University, "Interest rate adjustments are like a speedboat, while the balance sheet is like a tanker." She added, "The question is, are you willing to let the main policy tool wait for the tanker to turn?"

For Federal Reserve officials who wish to describe interest rate adjustments as "normalization," reducing the balance sheet to pre-crisis levels also fits this logic. Federal Reserve Governor Wall believes that compared to rapidly expanding the balance sheet during a financial crisis, a pre-determined, slow, and steady reduction process is unlikely to have a significant impact on the economy.

Wall stated at Stanford University that he is not concerned about a similar event in September 2019 - when the repo market briefly froze during a quantitative tightening process, forcing the Federal Reserve to increase reserves. He likened the Federal Reserve's balance sheet actions to that of a firefighter: "When you encounter bad economic outcomes, you take action like putting out a fire; once the fire is out, the water can drain away. And when the water drains away, the fire does not reignite. That's the asymmetry of policy actions." Currently, according to a new indicator introduced by the New York Fed - Reserve Demand Elasticity, reserves are still "abundant". This tool shows that changes in reserves have minimal impact on the federal funds rate, meaning the Fed can comfortably continue QT until 2025 without any unexpected economic or financial shocks.

Policymakers aim to further reduce the balance sheet until reserves reach a level of "adequacy" - a cash level judged based on actual conditions. Although this goal may take some time to achieve, Fed officials are not concerned and believe it can be achieved without causing any issues