Five years later, the dynamics of the Federal Reserve's balance sheet remain heavy

The Zhitong Finance APP noted that as the Federal Reserve continues to reduce its balance sheet, it still faces the same issues it encountered over five years ago.

Although market dynamics have changed, the main challenge for policymakers and investors is how to measure the liquidity of the financial system and avoid the turmoil that forced the Federal Reserve to intervene in September 2019 as it reduced its assets.

Since the start of its quantitative tightening policy in mid-2022, the Federal Reserve has reduced its assets by more than $2 trillion. Now, considering the levels of reverse repurchase agreements (an indicator of excess liquidity), near vacancy, and other factors such as bank reserves, many Wall Street strategists expect the Federal Reserve to end its quantitative tightening policy in the first half of this year. They also pointed out that the recent turmoil in the repurchase agreement market (most notably the turmoil at the end of September) was not a result of Federal Reserve actions, but rather a consequence of actions taken in 2019.

Deutsche Bank strategist Steven Zeng stated, "Some things may have changed since then, particularly the much larger size of the U.S. Treasury market and the very high issuance." The ability of dealers to act as intermediaries in the market is limited, which is also "a key distinction where repurchase volatility is a larger factor than reserve scarcity."

As early as 2019, the reserve scarcity caused by quantitative tightening, combined with various factors such as large corporate tax payments and Treasury auction settlements, led to a liquidity crunch that caused key lending rates to spike, forcing the Federal Reserve to intervene to stabilize the market.

Even now, the critical point of reserve scarcity remains unclear, although officials have indicated that it is the minimum comfort level for banks plus a buffer. The current balance stands at $3.33 trillion, which officials believe is ample, about $25 billion lower than the level when reserves began to be reduced two and a half years ago.

For some market participants, the lack of decline indicates that institutions' ideal reserve levels are much higher than expected, with some banks actually paying higher financing costs to retain cash. The latest Senior Financial Officer Survey released by the Federal Reserve last month showed that more than one-third of respondents are taking measures to maintain current levels.

The debate over adequate reserves and the endpoint of quantitative tightening is not new. At a meeting in January 2019, then-Federal Reserve Governor Lael Brainard warned against looking for the steep part of the demand curve for bank reserves, cautioning that this "would inevitably lead to increased volatility in the funds rate" and that "new tools would be needed to contain this."

Brainard also noted in subsequent meetings that the end of the Federal Reserve's quantitative tightening policy might coincide with fluctuations in reserve levels caused by the approaching debt ceiling, adding that reserve levels could differ significantly from normal balances Time flies, and concerns about the uncertainty of reserve prospects due to the debt ceiling have resurfaced. In the latest meeting minutes from December 17 to 18, System Open Market Account Manager Roberto Perli noted, "The debt ceiling may be restored in 2025, which could lead to significant changes in the Federal Reserve's liabilities, potentially challenging the assessment of reserve conditions."

Since discussions began in 2019, a notable development has been the establishment of the Standing Repo Facility (SRF), which was launched in July 2021. Eligible banks and primary dealers use the SRF to borrow funds overnight in exchange for U.S. Treasuries and agency debt, thus becoming a source of liquidity. By providing financing at rates set by the Federal Reserve, the goal is to ensure that the federal funds rate does not exceed the central bank's policy target range.

As early as the June 2019 meeting, Federal Reserve Chairman Jerome Powell recognized two potential attractions of the SRF: avoiding spikes in the federal funds rate and keeping bank reserves as small as possible.

However, given that quarter-end bank activities on September 30 pushed up financing rates, the balance surged to just $2.6 billion, the highest level before the daily operations were made permanent, so the tool remains underutilized. The Federal Reserve recently increased morning operations at the beginning of the year to further support market participants.

The main criticism of the tool is that it is not centrally cleared, so any activity increases balance sheet costs. This brings us back to the constraints faced by dealers and their intermediary capacity in the market.

Zeng from Deutsche Bank stated, "The discussions from 2019 should influence their views on the SRF to some extent today." At that time, "they believed that excessive and frequent use of the SRF would lead to adverse outcomes, and they were concerned about moral hazard, as with all liquidity support mechanisms."