The Fed quietly stops shrinking its bond pile

From April, the Federal Reserve will let only $5 billion of maturing US Treasury securities run off its balance sheet each month, down from $25 billion. The announcement came with little ceremony, but it all but ends the steady shrinking of the Fed's holdings of government debt under its quantitative tightening (QT) programme.

The cap on mortgage-backed securities stays at $35 billion a month, a limit that is rarely reached because homeowners with cheap fixed-rate loans are in no hurry to refinance. So the Fed's balance sheet will keep contracting slowly as mortgage bonds pay down, while its Treasury holdings stabilise. One governor, Christopher Waller, dissented, preferring to keep the old pace, though he supported the decision to hold interest rates steady.

Three years of runoff

Quantitative tightening began in June 2022, as the Fed fought the worst inflation in four decades. Its balance sheet had swollen to about $9 trillion after two rounds of emergency asset purchases, in 2020 and 2021, and officials wanted to shrink it while raising rates. At full speed the programme allowed $60 billion of Treasuries and $35 billion of mortgage bonds to mature each month without replacement. Last June the Treasury cap was cut to $25 billion, and holdings have now fallen below $7 trillion.

Runoff works without any sales. When a Treasury security held by the Fed matures, the Treasury pays the principal from its account at the Fed and must borrow the money from private investors instead. Those investors pay with deposits, which drain reserves from the banking system. Every dollar of runoff therefore means a dollar more of Treasury debt in private hands and, eventually, a dollar less of reserves.

Reserves are running low

Signalling a policy view had little to do with the decision. The plumbing of short-term money markets forced it. With the Treasury General Account swinging about and balances at the reverse repo facility close to their practical minimum, bank reserves held at the Fed have been drifting towards scarcity. Staff still remember the repo market seizure of September 2019, and they moved early, before strains appeared in overnight secured borrowing rates.

The reverse repo facility has been the shock absorber. At the end of 2022 money-market funds parked more than $2 trillion there, and for most of the QT programme the runoff drained that pool rather than bank reserves. The pool has since dwindled to a small fraction of its peak. From here, further shrinkage would come straight out of reserves, and nobody knows precisely where ample turns into scarce.

The debt ceiling complicates the timing. It came back into force in January, and the Treasury is using extraordinary accounting measures and running down its cash balance to keep paying its bills. That drawdown temporarily adds reserves to the system. Once Congress raises or suspends the limit, the Treasury will rebuild its account quickly by issuing bills, draining reserves at speed. Slowing QT now gives the Fed a buffer against that swing.

What happened in 2019

The precedent is uncomfortable. The Fed ran its first round of QT from 2017, confident that reserves remained plentiful. In mid-September 2019, a corporate tax date and a large Treasury settlement coincided, cash drained out of the repo market, and overnight repo rates briefly spiked to around 10 per cent. The Fed had to inject cash through emergency repo operations and then start buying Treasury bills to rebuild reserves, undoing part of what QT had achieved.

That episode taught two lessons. Demand for reserves is higher and more erratic than models suggested, because banks hold them to meet regulatory liquidity rules and to settle payments. And once strains appear, they spread fast. Since then the Fed has created a standing repo facility, which lends against Treasuries at a set rate, but banks have been reluctant to use it because of the stigma attached to borrowing from the central bank.

Fewer bonds for dealers to carry

The Treasury's Office of Debt Management gets welcome relief. The Fed will now reinvest all maturing principal above the $5 billion cap, which means private dealers and price-sensitive fund managers no longer have to find room for an extra $240 billion of government debt each year. The Treasury is running deficits above $1 trillion a year and must sell more debt regardless, so any reduction in what the market has to absorb helps.

The winners are the primary dealers, whose balance sheets are already stretched by the growing stock of Treasuries, and the Treasury, whose auctions should clear at slightly lower yields. Money-market funds and banks benefit from steadier overnight rates. Holders of long-dated Treasuries gain modestly, because the Fed's reinvestments reduce the net supply that private buyers must take. The main loser is the idea that central banks can return their balance sheets to anything like their pre-2008 size.

The case against stopping early

Critics argue that the Fed still owns far too much of the government bond market, that a large balance sheet blurs the line between monetary and fiscal policy, and that slowing QT now looks like easing while inflation remains above target. Mr Waller's dissent shows that at least one policymaker thinks reserves remain plentiful, and that the banking system has more room than cautious staff assume.

The counterargument is that the costs are asymmetric. Stopping a little early costs little, since the Fed can resume runoff later. Stopping too late risks another 2019, or something worse in a market that is larger and more leveraged. Watch the effective federal funds rate relative to the interest the Fed pays on reserves, use of the standing repo facility, and the size of the Treasury's cash balance once the debt ceiling is resolved.

The Fed has chosen calm funding markets and orderly Treasury auctions over finishing the job of shrinking its balance sheet, and dealers will probably notice the difference at auctions within weeks. The bigger test comes when the debt ceiling is lifted and the Treasury rebuilds its cash pile. If repo rates stay calm through that drain, the Fed will have judged it right; if they spike, full reinvestment of all maturing Treasuries will follow quickly.