Although many market participants focused their attention on the trend of this year's interest rate path in the Federal Reserve minutes last night, there is still a key "detail" in this 10 page Federal Reserve minutes that may not be overlooked by investors, which is the Fed's balance sheet reduction process.
The minutes of the December meeting of the Federal Open Market Committee, released overnight, show that Federal Reserve officials are trying to find a suitable time to start considering how to withdraw from the balance sheet tightening action, opening the door to a significant shift in the Federal Reserve's monetary policy.
According to this latest summary, several attendees suggested at the December meeting that discussions should begin on the decisive technical factors for when the Federal Reserve will slow down quantitative tightening (QT). These participants pointed out that the scale reduction plan indicates that when the bank's reserve balance is reduced to a level slightly higher than that consistent with sufficient reserves, the pace of scale reduction can be slowed down first and then completely stopped.
These attendees also suggested that it is best for FOMC to start discussing the technical factors guiding the decision to slow down the scale reduction speed before making a decision, in order to provide appropriate advance notice to the public.
In the past year and a half, the Federal Reserve policymakers have been carrying out a work that complements the Federal Reserve's aggressive interest rate raising cycle, that is, to continuously shrink the overall size of its balance sheet - the Federal Reserve has allowed up to $60 billion of U.S. treasury bond bonds and up to $35 billion of institutional bonds to "expire and not renew" every month. During this period, the size of the Federal Reserve's balance sheet has significantly decreased by over $1 trillion, to over $7.7 trillion as of the end of last year.
However, in recent weeks, a debate arising from this has also been rapidly fermenting - many market participants question whether the Federal Reserve has misjudged a point: the extent to which it can tighten without causing chaos in markets such as overnight repurchase agreements.
Although the current reserve balance of banks on the Federal Reserve's balance sheet is still about $3.48 trillion, far higher than the level when the Fed began to shrink its balance sheet in 2022, many market participants are still concerned that the size of reserves may not be as abundant as Federal Reserve decision-makers believe. Federal Reserve officials were taught a lesson in 2019 when overnight market interest rates surged fourfold to 10%, forcing the Federal Reserve to take emergency intervention measures.
Last week, the high volatility of benchmark interest rates in the financing market, such as the guaranteed overnight financing rate (SOFR), which soared to record levels, has raised concerns among some traders that a "money shortage" may resurface. Meanwhile, the usage of the Federal Reserve's overnight reverse repurchase tool has rapidly shrunk to about $720 billion at the beginning of the new year. The Federal Reserve's overnight reverse repo tool can be understood as a reservoir of idle funds for non banking institutions, where the Monetary Fund stores cash and can also act as a buffer for bank reserves.
It can be confirmed that compared to four years ago, the recent market volatility is still relatively light and there is no need for immediate intervention from the Federal Reserve. However, recent market changes have highlighted the increasingly delicate balance between the Federal Reserve, banks, and other institutions, which helps to ensure the normal operation of the overnight financing market.
The volatility of the short-term financing market may hinder the Federal Reserve's ability to manage monetary policy. At a time when the benchmark interest rate in the United States is already at a 20-year high, financing imbalances may also put pressure on the borrowing costs of the government and other institutions, thereby posing risks to the overall economy.
"The Federal Reserve is like a scout, they always want to be prepared. On the one hand, preparing in advance for the end of the QT is a good thing. On the other hand, they also have to figure out how to do this without sending signals to the market that the QT is coming to an end."
Currently, many market participants are considering the second or third quarter of this year as the timing for the Federal Reserve to exit its balance sheet tightening policy.
Blake Gwin, head of US interest rate strategy at Royal Bank of Canada Capital Markets, said, "As the saying goes, everyone has a plan until they are hit." He believes that the Federal Reserve will gradually withdraw from QT starting in mid-2024.
"The last time they (Federal Reserve officials) were hit by a surge in repurchase rates in September 2019 and immediately turned the tide."