Fed’s Powell appears to see plenty of room to run on balance sheet drawdown

By Michael S. Derby

WASHINGTON (Reuters) – Federal Reserve Chairman Jerome Powell said on Wednesday that financial conditions are likely to allow the central bank to press forward with the drawdown of its massive balance sheet through the remainder of the year.

As the Treasury moves toward selling massive amounts of debt to rebuild its financial position after the resolution of the debt ceiling battle, Powell noted there is a “very high” level of reserves in the banking system and stashed away at the Fed’s reverse repo facility.

Because the system is so flush with cash, it gives the Fed ample room to press forward with letting Treasury and mortgage bonds run off its balance sheet. “We don’t think reserves are likely to become scarce in the near term or even over the course of the year,” Powell said.

That observation implied the Fed can continue to move just under $100 billion per month from its balance sheet, as it has been doing since last summer, possibly into 2024. The balance sheet drawdown has complemented the central bank’s more high- profile campaign of rate rises, which has seen its interest rate target go from near zero in March of last year to its current 5% to 5.25% range.

The Fed on Wednesday refrained from another rate hike at its Federal Open Market Committee meeting but said it’s eyeing a cumulative half percentage point in further increases this year.

There have been ongoing questions regarding how long the Fed can go with its balance sheet drawdown, given that the last time it did something similar reserves ran scarce in September 2019, forcing the Fed to take action to rebuild them by borrowing and buying bonds.

A shortage of reserves challenges the Fed’s ability to control its short-term rate target, although the existence of a new and untested facility, called the Standing Repo Facility, offers a liquidity safety valve that should in theory prevent a replay of the 2019 volatility.

Still, some forecasters have begun to believe that the impact of the existing balance sheet drawdown, which has taken Fed holdings from just shy of $9 trillion last summer to the current $8.4 trillion, coupled with Treasury borrowing, could make bank reserves scarce enough to make it possible to end active Fed efforts to reduce holdings sometime in the final months of this year.

Powell also said in the press conference that the Fed is not considering tweaking the setting on its reverse repo facility, which has been pulling in over $2 trillion per day for months, to induce some of that cash to flow out into the broader economy.

Market analysts believe new Treasury issuance will bring a quick and noticeable contraction in the reverse repo facility, which exists to put a floor underneath short-term interest rates. The reverse repo facility stood at $2.109 trillion Wednesday.

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