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Debt Limit Debate Could Hasten End of Fed Tightening

By reducing its bond portfolio by up to $95 billion a month, the central bank drains liquidity from the US financial system, thus complementing its interest rate hikes in the fight to contain inflation. Therefore, an early end to quantitative tightening could provide some relief to the US economy.

Through a complex series of reactions, the restrictions placed on the Treasury Department by the debt limit could end up amplifying part of the impact of the quantitative tightening later this year.

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Commercial bank reserves held at the Fed are part of the financial foundation of the US. When the Fed first went into quantitative tightening and reserves fell in 2018 and 2019, stocks fell and money markets froze. The dynamics caused by the debt limit could have the effect of a more rapid drawdown of reserves later this year, which could bring the end of quantitative tightening earlier, even if the US avoids a default.

Federal Reserve break

“It’s a complicating factor, because we just don’t know how all these things are going to react to each other,” he said. Blake Gwinndirector of US rates strategy at RBC Capital Markets. “There are really two main sources of uncertainty around this process. We don’t know what the right level of reserves is,” nor how long it will take to get there, he said. And the debt limit “adds uncertainty about the rate at which we are reaching that final level.”

It’s all a big change from just a few weeks ago, when the Fed concluded that the maturity of its bond portfolio was going “smooth,” according to minutes from its December policy meeting.

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That process can reduce liquidity through two main channels: bank reserves and the reverse repurchase, which is used to deposit money market funds. It can make a difference which one is reduced, because economists see reserves as having a more powerful role in supporting credit in the economy.

When the Treasury uses its cash pile and has to start restricting its sales of government securities later this year, there will be less supply of Treasury bills for money market funds. That means they will probably need to put more into the reverse repurchase instrument.

What could happen then is that the other channel affected by the Fed’s quantitative tightening, bank reserves, ends up shrinking faster.

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“All of this money will be placed in the Fed’s Reverse Repurchase Facility,” said John Velismacroeconomic and foreign exchange strategist at BNY Mellon. “That will reduce bookings, as it is a mirror image.”

The president of the Federal Reserve, Jerome Powell, has not recently provided any updates on the timing of the central bank’s anticipated quantitative tightening. He said last July that the Fed’s model suggested it could run for two to two and a half years before bank reserves fell to a “new equilibrium” level after they rose during Fed easing in the era of the pandemic.

The president of the Federal Reserve Bank of New YorkPresident John Williams said last week that policymakers are now looking at risks related to the debt limit and the potential volatility of reserve balances.

Source: Gestion

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