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Rethinking QT, Are There Practical Limits on What the Fed Can Do?

I likely made an error in my last Quantitative Tightening (QT) post. Let's correct that, then investigate proposed limits on QT and a proposed optimum level.
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Image courtesy of Vanguard. Link below.

Image courtesy of Vanguard. Link below.

The Fed Will Not Hit its Own Quantitative Tightening Schedule

On July 28, I proposed The Fed Will Not Hit its Own Quantitative Tightening Schedule

That may be correct, but if so, for a reason other than I suggested. First consider a chart I posted.

Fed's Mortgage Backed Securities forecast from NY Fed. Annotations by Mish.

Fed's Mortgage Backed Securities forecast from NY Fed. Annotations by Mish.

The Fed has a current cap of $17.5 billion on MBS QT. In the last two months, the Fed has hit $1.7 Billion and $1.1 billion of that cap, rounded to "2" and "1" in the above chart.

Reverse Engineering QT

I suggested that due to falling existing home sales, the Fed would not come close to the cap.

Not so, says John Comisky in Reverse Engineering QT

  • So how can we prove the FED has reduced its reinvestment purchases? By looking here: https://www.newyorkfed.org/markets/soma-holdings (SOMAH)
  • Starting with UST. Coupon USTs typically mature the 15th and last day of the month. You can see the specific UST the FED owns at SOMAH (e.g. click on T-Notes and T-Bonds or TIPS tab), including their value and maturity date. You can also adjust the week-of date for the SOMAH to see how it looked (anc changed) from week to week.

I never doubted the Fed would hit its Treasury Cap. But what about mortgage backed securities?

The bulk of the MBS purchases takes 1-2 months to settle. There is a significant lag. As a result, almost all the MBS adding to the SOMAH in June and July was actually purchased prior to the start of QT. But that is all passed now so MBS BS reductions should reflect 17.5b in August. But do note that there will be a similar lag for when QT ramps to a 35b cap, will just reflect a 17.5b drop in September and October as the MBS purchased in July-Aug settles.

Speaking of that 35b cap, will the FED ever hit that? Maybe, but it couldn’t hit it today and wont hit it unless prepayment speeds rise a bit. Today the FED is receiving about ~29.5b in principal payments/prepayment from all its securities each month. So when the upped cap comes into play the FED will just stop buying MBS altogether (they are purchasing about 12b a month today to reinvest the ~29.5b payments received minus the cap). They might eventually actively sell MBS but they have announced no concrete plans to do so of yet.

Assuming Comisky is correct, that prepayment figure is likely to drop because of declining existing home sales, but it will not be as radical as I suggested.

Practical Limits on QT

Let's explore another QT idea with a Tweet Thread.

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  1. QT will probably end in early 2023, and not because of recession. It will stop because the Fed can't shrink its balance sheet past $8trn ($8.9trn now) without introducing problems for the system. 
  2. Everyone concentrates on the assets that the Fed has on the B/S. It's basically all Treasuries and MBS. But, like any bank, assets must = liabilities. It's the liabilities which tell us how big the balance sheet must be.
  3. It's when you look at the liabilities that the reason for why the B/S can't shrink all that much. The structure of the financial system has changed a lot since the GFC through regulation and the fear of another contagion driving deposits far more than they did pre-2007.
  4. What are the liabilities? One: Physical currency outstanding Two: Reverse Repo balances. Three: Reserves held by commercial banks. Each has a minimum in the new post-GFC world.
  5. Currency outstanding. This is at $2.3trn, and represents the amount of printed notes and coins in circulation. This obviously cannot fall without destroying notes and coins which is not going to happen. So the B/S must be at least $2.3trn in size.
  6. Reverse Repo. Due to regulation changes post-GFC, money market funds were dissuaded from investing in short-term bank paper, requiring govt paper only. There isn't enough T-bills to satisfy this need. So the Fed creates an asset (RRP) for money market funds to invest in.
  7. Reverse Repo. To create this asset they borrow from the MMF to buy Treasuries on "loan", creating a short-term security out of a long-term. This is $2.3trn. It has grown because rates are increasing and demand for short-term has increased. This won't change for now.
  8. This is a change mostly from regulation, permanently increasing the BS size. This puts the minimum Fed balance sheet size so far at currency ($2.3trn) + RRP ($2.3trn) = $4.6trn.
  9. Excess reserves were at zero pre-GFC. This is because banks were searching for more return anywhere, driving short-term interbank lending. This totally changed post-GFC because of regulation, and fear. [See Chart Below]
  10. Wile this series is old, you can see how interbank lending collapsed and never recovered. It probably won't. Banks are wary of contagion, and prefer the safety of reserves over risky interbank lending. Short-term lending puts your deposit attraction ability at risk. [See Chart Below]
  11. The banks are also deposit rich, with no where to lend (the exact opposite of 2006). This has driven demand for Fed reserves as the short-term asset of choice. Barcap puts the minimum for bank reserves at about $2.7trn before huge demand for safe assets hurts the system.
  12. Adding the minimums... Currency ($2.3trn) + RRP ($2.3trn) + Minimum bank reserves ($2.7trn) = $7.3trn Add the current deposit by the US treasury at the Fed ($0.7trn) MINIMUM B/S SIZE = $8trn given today's dynamics. It can reduce more if RRP demand goes away (unlikely).
  13. The fantasy that the Fed can sell $8trn worth of Treasuries through QT is just that. Fantasy. In reality the balance sheet can be shrunk around $900bn. After that, QT is over.

New Optimum Balance Sheet

On May 16, 2022, Vanguard commented on The Fed's plan to shrink its balance sheet, quickly

Estimate for the balance sheet roll-off path assumes that monthly proceeds of $30 billion in Treasury securities and $17.5 billion in agency mortgage-backed securities (MBS) won't be reinvested in the three months beginning June 1, 2022. Beginning September 1, 2022, monthly Treasury and MBS roll-off caps will rise to $60 billion and $35 billion, respectively. For MBS, roll-off after September 1, 2022, assumes forecasted MBS prepayments per the Federal Reserve Bank of New York's "Federal Reserve Asset Purchases: The Pandemic Response and Considerations Ahead," March 2, 2022. Consistent with "Plans for Reducing the Size of the Federal Reserve's Balance Sheet," May 4, 2022, the estimated roll-off pace slows and then stops when the balance sheet is within range of optimal to allow assets to grow into the optimal range. The optimal balance sheet estimate comprises a constant $1.5 trillion level of required reserves, currency in circulation grown by 4% nominal GDP, and a constant 2.8% of GDP allocation for Treasury general account and other liabilities as per Fed Chairman Jerome Powell's March 8, 2019, speech "Monetary Policy: Normalization and the Road Ahead."

Two Views

  • $4 Trillion is Optimal
  • The Fed cannot come close

One thing is clear, the Fed's balance sheet is going to be significantly padded for a long time vs 2009, even if the Fed meets its schedule for a while.

This post originated at MishTalk.Com.

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