Evening Brief – 06.05.23
In tonight’s Evening Brief we wrap up our three-stage look at the possible ramifications of the now signed federal debt limit deal – the end of quantitative tightening (QT).
After Congress raised the debt ceiling in August 2019, Treasury cash-raising eroded liquidity to the point where the US banking sector faced a mini-repo crisis in September. At first, the Federal Reserve responded by making emergency loans available on demand.
However, perhaps realizing it had extended its skis too far with QT, the central bank swiftly found a permanent remedy by shifting to quantitative easing (e.g., raising the stock of bank reserves).
The stated objective of the Fed’s current QT program is to reduce reserves to “just adequate” levels, implying it wishes to avoid depleting reserves to insufficient levels, which would risk a repeat of the 2019 mini-repo crisis.
It might be challenging to determine where the boundary between “just adequate” and “sub-adequate” actually resides. However, it is highly likely that the Fed will aim for a level of reserves that, after adjusting for nominal growth, is comparable to the level that prevailed in late 2018 or early 2019. According to findings by the New York Fed staff, this indicates a level of reserves equal to 8%-10% of nominal GDP.
Overall reserves are almost $700 billion above this range. If additional reserves are required, financial institutions have the option of borrowing from the Fed; however, this must be done under the condition that they have adequate collateral. But since there is an uneven distribution of reserves and collateral, certain banks may still run into difficulties.
If the banking system exhibits no signs of liquidity strains, the Fed will not be required to restart QE. However, QT could still end. QT targets the level of non-borrowed reserves, which is currently only about $400 billion above the desired range.
Reserves will decline within the desired range if the $540 billion the Treasury issues to replenish its cash account comes primarily from bank reserves (rather than the Fed’s reverse repo facility). So, even in the absence of stress, the Fed may signal the end of QT sooner rather than later.