Fed balance-sheet volatility still weighs heavily over five years.

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(Bloomberg) — As the Federal Reserve unwinds its balance sheet, it’s still caught up in the same issues it faced five years ago.

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While market volatility has evolved, the main issue facing policymakers and investors is how to measure volatility in the financial system and avoid the turmoil that forced the Fed to intervene in September 2019.

The central bank has reduced its assets by more than $2 trillion since the so-called quantitative easing process began in mid-2022. Now, a large number of Wall Street strategists expect the Fed to end QT in the first half of the year, given levels on the reverse facility, excess liquidity, near-empty and other factors such as bank reserves. They also note that the recent turmoil in the market for repurchase agreements, particularly in late September, was not the result of Fed actions as it was in 2019.

“Some things may have changed since then, especially that the Treasury market is very large and the supply is very high,” said Steven Zheng, a strategist at Deutsche Bank. Restrictions on dealers from intermediation in the market also “contribute more to repo volatility than reserve shortages, which may be the key difference.”

In the year In 2019, a confluence of factors—including a lack of reserves due to QT—combined with a large corporate tax bill and a Treasury bid led to a liquidity crisis, sending key lending rates down and forcing the Fed to intervene to stabilize the economy. Market.

It is still not clear where that reserve shortfall point will be, although officials say it is banks’ very low comfort level and holdings. The balance is currently at $3.33 trillion, a level officials believe is too high, and about $25 billion below what it was when the break began two and a half years ago.

For some market participants, the shortfall means that institutions’ comfortable reserve levels are higher than expected, and some banks are paying higher funding costs to hold onto cash. Results of the Fed’s Chief Financial Officer Survey, released last month, showed that more than a third of respondents were taking steps to maintain the status quo.

The debate about adequate reserves and the QT break point is not new. At a meeting in January 2019, then-Federal Governor Lael Brainard warned against seeking the steeper part of the demand curve, which would “necessarily lead to increased volatility” and that “new instruments will be needed to contain this.” “

Later in the meeting, Brainard expressed concern that the end of the Fed’s QT could coincide with fluctuations in reserves associated with the approach to the debt ceiling, saying the level could be very different from the normal balance.

Fast forward, and worries about the debt limit are weakening the outlook for reserves. In minutes gathered last December 17-18, System Open Market Account Manager Roberto Perelli said that the possibility of restoring the debt limit in 2025 could cause a significant change in the Federal Reserve’s liabilities, which could create challenges in assessing reserves. Circumstances”

In the year One significant evolution since the 2019 talks is the establishment of a permanent repo facility, introduced in July 2021. The SRF is a liquidity source of treasury and agency debt that eligible banks and primary dealers use to borrow money overnight. By providing financing at rates set by the Fed, the goal is to ensure that the federal funds rate does not move outside the central bank’s policy target range.

At the June 2019 meeting, Chairman Jerome Powell saw two potential attractions for the SRF: avoiding an increase in the federal funds rate and maintaining bank reserves as much as possible.

But as the facility was underutilized on Sept. 30, as quarter-end banking activity pushed liquidity higher, balances rose to just $2.6 billion, the highest level before day-to-day operations were made permanent. The Fed recently added year-round morning operations to further support market participants.

A major criticism of the institution is that it is not centrally cleared, so any activity adds to the balance sheet costs. That circles back to the constraints faced by sellers and their ability to mediate in the market.

“The 2019 discussions should inform their thinking around the SRF at some point today,” said Detouche Bank’s Zeng. At the time, “excessive and too frequent exposure to SRF was viewed as a negative outcome, and moral hazard risk was a concern as with all liquid backstop facilities.