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Risk of Early End to Fed Quantitative Tightening if Debt-Limit Fight Continues

Some economists and bond-market participants believe that the Federal Reserve's quantitative-tightening program could be cut short if US politicians cannot agree on raising the national debt limit. This disagreement could have serious consequences for the US economy.

January 24, 2023
5 minutes
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Some economists and bond-market participants believe that the Federal Reserve's quantitative-tightening program could be cut short if US politicians cannot agree on raising the national debt limit. This disagreement could have serious consequences for the US economy.

The central bank is draining liquidity from the US financial system by shrinking its bond portfolio by up to $95 billion a month. This is in addition to its interest-rate hikes in the battle to control inflation. An early end to QT could therefore provide the US economy with some relief.

The debt limit could end up amplifying the impact of quantitative easing later this year. This is because the Treasury Department will be constrained in its ability to borrow, and this could lead to higher interest rates.

Commercial bank reserves play a vital role in the US financial system, and when the Fed began reducing them in 2018 and 2019, it caused stock prices to fall and money markets to freeze up. If the US government defaults on its debt this year, it could force the Fed to end its reduction of reserves sooner than planned, potentially leading to more market instability.

According to Blake Gwinn, head of US rates strategy at RBC Capital Markets, there are two major sources of uncertainty around the Fed's rate-tightening process. The first is the lack of clarity around what the "right" level of reserves is, and the second is the debt limit. Gwinn said that these uncertainties make it difficult to predict how the rate-tightening process will play out.

The Fed's bond-portfolio runoff is proceeding much differently than it was just weeks ago, according to minutes from the December policy meeting. This is a big change that could have major implications for the economy.

There are two main ways that runoff can reduce liquidity: by reducing bank reserves and by reducing the amount of money available through the reverse repurchase facility (RRP). The latter is a key source of funding for money market funds. economists believe that reserves play a more important role in supporting credit growth in the economy, so a reduction in reserves can have a greater impact.

As the Treasury begins to draw down its cash reserves and restrain its sales of government securities later this year, there will be less Treasury bills available for money market funds. This will likely cause them to park more of their funds in the reverse-repo facility.

If the Fed begins to shrink its balance sheet, it could have a ripple effect on other channels, such as bank reserves. This could cause reserves to shrink at a faster pace.
John Velis, a foreign-exchange and macro strategist at BNY Mellon, said that all of the cash from the stimulus package will be put to work in the Fed's RRP facility. This will reduce the amount of reserves in the system, as it is a mirror image of the stimulus.

If reserves get dangerously low, you could start to see some hiccups in markets, warned one economist. This could cause problems for businesses and consumers alike. It's important to keep an eye on reserves and take steps to ensure they don't get too low.

Fed Chair Jerome Powell has not recently offered any update to the central bank's anticipated QT timeline. Last July, he said that the Fed's model suggested QT could run for two to 2 1/2 years before bank reserves got down to a "new equilibrium" level after they surged during pandemic-era Fed easing.

Last week, John Williams, President of the Federal Reserve Bank of New York, said that policymakers are taking a look at risks surrounding the debt limit and potential volatility to reserve balances.

"We're clearly studying those things and making sure we think through them," he told reporters. However, he didn't anticipate an earlier end to quantitative easing than expected, pointing to the surplus of funds in the RRP facility that can still be used. "It's a process that's going to take time and we'll be watching carefully," he said.

Subadra Rajappa, head of US rates strategy at Societe Generale SA, said that the Fed's reverse repo program may lead to a shortage of reserves.

Dallas Fed President Lorie Logan noted last week that the Fed's new standing repurchase facility could serve as a backstop if reserves suddenly fall too low. Logan, who previously oversaw balance-sheet management at the New York Fed, said that the facility could help firms borrow cash as needed.

This facility has not been tested and is subject to limits, but it could potentially serve as an early warning sign that reserves are getting scarce.

Banks' reserve balances at the Federal Reserve have already decreased by about $900 billion, to around $3.1 trillion. In the near future, they are probable to see some growth as the Treasury Department decreases its cash balance at the Federal Reserve. Once that process is completed, they are probable to resume their decrease.

Some Fed watchers had anticipated an end to the bond-portfolio runoff at some point this year, even before the latest debt-ceiling drama unfolded. That's part of a broader debate over whether the Fed will have to abandon monetary tightening and shift toward easing, amid widespread expectations of a recession kicking in.

If the debt-ceiling impasse is finally resolved, it could have a surprisingly powerful impact on bank reserves. Once the Treasury has a free hand, it is likely to unleash a massive series of bill sales in order to raise cash. This could mop up so much money that it could cause a sharp contraction in bank reserves.

Some observers say that the supply of T-bills could surge by $500 billion to $800 billion over the course of several months.

Derek Tang, an economist with LH Meyer, believes that quantitative easing (QE) will continue until 2024. He believes that reserves may increase if banks begin to compete more intensely for deposits, drawing cash away from money funds and the reverse repo facility. This is a scenario that more Fed officials have pointed to in the past week.

Tang noted that the Fed seems more confident that the market will be able to redistribute liquidity where it is needed.

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