Fed Will Weigh Resuming Balance Sheet Growth at October Meeting

A sudden spike in overnight lending rates this week is forcing the Federal Reserve to consider growing its holdings of Treasury securities for the first time in five years, putting a decision on the agenda for its meeting next month.

Fed Chairman Jerome Powell said Wednesday the central bank would be studying whether to increase its holdings, sometimes referred to as its balance sheet, carefully before approving any action at its Oct. 29-30 meeting.

“It is certainly possible that we will need to resume the organic growth of the balance sheet earlier than we thought,” he said at a news conference. “We’ll be looking at this carefully in coming days and taking it up at the next meeting.”

A decision to resume the growth of the Fed’s balance sheet wouldn’t mark the start of a new bond-buying program to stimulate economic growth by lowering long-term interest rates, like those the Fed began in several rounds after the 2008 financial crisis.

Instead, the Fed would begin buying small amounts of Treasury securities on a regular basis to prevent the amount of money in the banking system from declining. This marks a return to the normal precrisis practice of allowing the Fed’s balance sheet to grow in line with the broader economy.

A decision to do so also wouldn’t on its own fix recent cash shortages in money markets. The New York Fed injected more than $200 billion into those markets over three days this week to help pull down interest rates.

Fed officials didn’t decide the matter this week, instead preferring to study how the financial system is digesting their five-year effort to drain reservoirs of cash to reverse their crisis-era stimulus.

Analysts at Evercore ISI expect the Fed will need to buy $8 billion to $14 billion in Treasurys every month to prevent bank deposits, known as reserves, from declining; that is on top of around $35 billion in Treasurys it is buying to replace retiring bonds and mortgage-backed securities.

Central bank officials said this spring that they would stop shrinking their Treasury holdings, a decision that took effect last month. But they never said when they would allow their holdings to grow again.

The Fed’s balance sheet is composed of $3.8 trillion in assets — primarily Treasury securities and mortgage-backed securities — and liabilities, including the reserves that were created to purchase the assets.

The Fed stopped buying bonds to spur the economy in 2014 and began slowly shrinking the holdings in 2017 to reduce the stimulus, which drained reserves from the system. Reserves have fallen to less than $1.5 trillion from a high of $2.8 trillion

In the normal course of business, the Fed’s balance sheet should grow to keep up with demand for the Fed’s liabilities, which include currency in circulation and the Treasury’s general financing account.

The amount of currency in circulation has grown to $1.7 trillion from less than $800 billion in 2007. During periods when the Fed has held its balance sheet steady, reserves decline if the Fed’s other liabilities rise, removing cash from markets.

The Fed’s balance sheet doubled between 1994 and 2007 — well before it started its bond-buying stimulus programs, sometimes called quantitative easing, or QE.

“By expanding its balance sheet, the Fed would simply accommodate the market demand for liquidity, not provide excess liquidity, which is a characteristic implicit in QE,” said Roberto Perli, an analyst at Cornerstone Macro, in a note to clients Tuesday.

The decision to resume growth of the balance sheet isn’t a big surprise. Several Fed officials said earlier this year they didn’t want to reduce reserves to levels that might fuel volatility in short-term money markets. A seasonal cash crunch on Monday, however, did just that.

Corporate tax payments and settlements of government bond sales resulted in a large transfer of cash from the banking system to the Treasury, fueling a spike in overnight lending rates, including the Fed’s benchmark federal-funds rate.

The fed-funds rate traded at 2.3% on Tuesday, according to the New York Fed, rising above the central bank’s target range between 2% and 2.25%.

Separately, the Fed lowered the range by a quarter percentage point on Wednesday to cushion the economy against risks from trade policy uncertainty and slowing global growth.

Tuesday’s rate jumps raise the possibility the Fed misjudged the appropriate level of reserves or that broader plumbing issues are interfering with the ability of banks and other broker-dealers to move cash, which could require a larger volume of reserves to keep markets running smoothly.

Determining when to stop the decline in reserves is “is probably more art than science,” said Boston Fed President Eric Rosengren in an interview earlier this year.

When it comes to determining the right point to stabilize reserves, “we’ve always said that the level is uncertain,” Mr. Powell said Wednesday. “I think we’ll learn quite a lot in the next six weeks.”

Fed officials face other thorny questions after that, including whether to change the mix of the Treasury securities they are purchasing and whether to become more involved in money markets by creating a new standing facility that would reduce volatility in participants’ demand for cash.
Source: Market Watch