What does the Federal Reserve want to reduce its balance sheet while cutting interest rates?

The Zhitong Finance App learned that although people are concerned about the interest rate measures the Federal Reserve may take in 2024 and beyond, another policy area, although tedious, is just as important. This area of policy is the Federal Reserve's continued reduction in its balance sheet, called quantitative austerity.

Although there seems to be a contradiction between the Federal Reserve's easing policy by lowering interest rates on the one hand and reducing the balance sheet austerity policy, the current balance sheet of the Federal Reserve has not brought major news, which is good news for the market.

The Federal Reserve's balance sheet is critical to the execution of its monetary policy. Banks hold reserves in the Federal Reserve and receive risk-free returns as a result, which is equivalent to setting a bottom line for interest rates throughout the financial system. The Federal Reserve guided the federal funds rate through this mechanism, which is its main benchmark interest rate, and lowered its target range to 4.75% to 5% in September. Additionally, banks and other financial institutions can lend their US Treasury bonds to the Federal Reserve through “repo” (repo) transactions in exchange for cash to meet liquidity needs.

In times of financial crisis or stress, the Federal Reserve can use its balance sheet to quickly inject cash into the economy and keep credit flowing. The Federal Reserve took large-scale action during the COVID-19 pandemic, and its balance sheet expanded from about $4.2 trillion in early 2020 to a peak of nearly $9 trillion in 2022, when the Federal Reserve bought a large number of US Treasury bonds and mortgage-backed securities.

The Federal Reserve has been shrinking its balance sheet since March 2022, and as of last week, its size had dropped to $7 trillion. Federal Reserve officials slowed this process in June. The Federal Reserve currently allows up to $25 billion in US Treasury bonds and $35 billion in mortgage-backed securities to mature each month without reinvesting the proceeds.

By allowing these securities to mature naturally without reinvesting them, the Federal Reserve gradually reduces bank reserves, which means that banks have less cash available to lend, which may put upward pressure on bond yields.

This seems to contradict the Federal Reserve's move to cut interest rates. San Francisco Federal Reserve Chairman Daly explained this conflict as a matter of time. “Interest rate adjustments are like a speedboat, and a balance sheet is like an oil tanker,” she said at an event at NYU. She added, “The question is, are you willing to let the main policy tool wait for the tanker to turn?”

For US Federal Reserve officials who want to describe interest rate adjustments as “normalization,” reducing the balance sheet to pre-crisis levels also fits this logic. Federal Reserve Governor Waller believes that compared to rapidly expanding the balance sheet during the financial crisis, a pre-defined, slow, and steady reduction process is unlikely to have much impact on the economy.

Waller said at Stanford University that he wasn't worried about a similar incident in September 2019 — during a quantitative austerity process, the repurchase market froze for a while, and the Federal Reserve was forced to increase reserves. He likened the Federal Reserve's balance sheet action to a firefighter: “When you have bad economic results, you act like throwing water to put out a fire; once the fire is out, the water can drain away. And when the water drains away, the fire doesn't reignite. This is the asymmetry of policy action.”

Currently, reserves are still “sufficient” according to a new indicator introduced by the New York Federal Reserve — Reserve Demand Elasticity (Reserve Demand Elasticity). The tool shows that changes in reserves have little impact on federal funds rates, meaning the Fed can comfortably continue QT until 2025 without unexpected economic or financial shocks.

Policymakers want to keep shrinking the balance sheet until the level of reserves falls to “sufficient” — a level of cash judging by the actual situation. Although this goal may take some time to be achieved, Fed officials are not worried about it and believe that it is possible to achieve this goal without causing problems.