Roberto Perli, an executive at the Federal Reserve Bank of New York, has warned that the ongoing debt-ceiling impasse could disrupt the Federal Reserve’s balance-sheet runoff, potentially causing significant volatility in money markets. Perli explained that once the debt ceiling is resolved, the Treasury Department typically moves quickly to rebuild its cash reserves. This action, which involves increasing the Treasury’s cash pile (the largest liability on the Fed’s balance sheet), can lead to a sharp decline in other liabilities, especially bank reserves.
Perli, who oversees the central bank’s securities portfolio, highlighted the risks of this process, noting that the longer the debt-ceiling standoff continues, the higher the chance that, upon resolution, reserves will drop rapidly, triggering considerable instability in money markets.
The Impact of Quantitative Tightening (QT)
The Federal Reserve has been engaged in a process known as quantitative tightening (QT), where it reduces its balance sheet by allowing securities, such as Treasuries and mortgage-backed securities, to mature without reinvesting the principal. The Fed has been shrinking its holdings since June 2022. As of now, it is allowing up to $25 billion in Treasuries and $35 billion in mortgage-backed securities to mature each month.
Perli noted that although reserve conditions remain abundant at present, it is unclear when reserves will become scarce, and repo market pressures indicate that quantitative tightening may have gone too far. He pointed to the increasing share of interdealer transactions occurring above the interest rate on reserve balances, a sign that pressure is mounting.
Potential Repo Market Issues
Repo markets, which are essential for short-term funding, have been showing signs of strain. These pressures indicate that the Fed’s QT may be too aggressive, particularly as more transactions in the interdealer market are being conducted at higher rates than last year. This growing imbalance could potentially lead to disruptions in money-market rates, which would then ripple through financial markets.
Perli emphasized that while the Fed has not yet observed a scarcity of reserves, the growing pressures in the repo market suggest that the Fed may need to reconsider the pace and scale of its balance-sheet runoff.
Treasury Market Purchases After QT
As the Fed continues its balance-sheet runoff, the minutes from the January Federal Open Market Committee (FOMC) meeting revealed that policymakers discussed the need to slow or pause QT until lawmakers resolve the debt ceiling issue. Once the runoff concludes, there may be a need to structure secondary-market Treasury purchases in a way that better aligns the Fed’s portfolio with the composition of outstanding Treasury debt. This would require a gradual shift towards purchasing more T-bills, particularly to balance the Fed’s current overrepresentation of longer-term securities.
Perli noted that the Fed’s current Treasury portfolio is significantly underweight in T-bills, and its holdings are skewed towards coupon securities with longer maturities. He suggested that after the runoff, the Fed could gradually shift its purchases to T-bills to address this imbalance, though it would take years to do so without causing market disruptions.
Flexibility in Portfolio Composition
Federal Reserve Bank of Dallas President Lorie Logan, a former SOMA (System Open Market Account) manager, echoed Perli’s concerns, stating that it would be appropriate for the Fed to purchase more shorter-term securities in the medium term to bring its portfolio more in line with Treasury issuance. Perli emphasized that this strategy does not lock the Fed into a particular portfolio structure for the long term, allowing policymakers flexibility to adjust in the future to meet evolving policy goals.
Standing Repo Facility and Potential Technical Exercises
On the Standing Repo Facility (SRF), Perli acknowledged that the addition of a morning operation at the end of 2024 helped ensure smooth functioning in the funding markets. Looking ahead, he suggested that there could be a technical exercise at the end of March to mitigate potential volatility in short-term rate markets.
The Fed is exploring ways to improve the efficacy of the Standing Repo Facility, as indicated by recent FOMC minutes. Several officials supported efforts to make the SRF more effective, potentially introducing new measures to support liquidity and stabilize money markets during periods of heightened volatility.
Conclusion
The ongoing debt-ceiling impasse has introduced significant uncertainty in money markets, and while the Fed’s balance-sheet runoff has yet to cause a crisis, the potential for volatility remains high. The resolution of the debt ceiling and the subsequent rebuilding of Treasury reserves could put immense pressure on bank reserves, further exacerbating repo market stresses. Moving forward, the Fed will need to carefully navigate these dynamics to ensure stability in financial markets.
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