February 16, 2024 (MLN): The US Federal Reserve is likely to continue to run down its holdings of US Treasury (UST) and mortgage-backed securities (MBS) until end-2024, despite the prospect of interest rate cuts from June, Fitch Ratings says in its latest economics dashboard.
Sharply falling use of the Fed’s overnight reverse repo facility (RRP) is keeping bank reserves higher than expected as the Fed reduces its balance sheet.
The Fed intends to slow and then end quantitative tightening when bank reserves are ‘somewhat’ above the level judged to be consistent with ‘ample’ reserve balances.
The challenge for the Fed is that this ‘ample’ minimum reserves floor is unknown. The money market stress in September 2019 revealed the threshold was much higher than previously thought.
There are a few concerns that reserves are close to the threshold now, with overnight interest rates trading in the lower half of the Fed’s target range.
Bank reserves were $3.4 trillion in January 2024 (12.6% of GDP), compared to $1.4tr (6.7%) in September 2019.
The sharp fall in the RRP from $2.6 trillion in May 2023 to $980 billion in January 2024 has boosted reserves. The RRP drains reserves as counterparties, typically money market funds lend funds directly back to the Fed.
Nevertheless, recent Fed commentary has alluded to a reserves floor of 10%-11% of GDP, or $2.8tr-3tr. This is higher than estimates from around a year ago.
Fitch has constructed a Fed balance-sheet scenario assuming cash demand grows in line with GDP, Treasury deposits (TGA) stay at $865 billion and the RRP declines further to $360 billion by year-end.
This shows that continued falls in Fed securities holdings tapered to $60bn a month from June (from the current limit of $95bn) would leave reserves at $3.2tr by end-2024, somewhat above ample.
