NEW YORK: Fixed‑income markets are over-estimating the impact of potential changes to the Federal Reserve’s (Fed) balance sheet policy, which are likely to be slow and limited, according to the Canadian Imperial Bank of Commerce (CIBC).
The Fed isn’t likely to start shrinking its US$6.7 trillion balance sheet until next year, said CIBC’s strategists Michael Cloherty, Anjun Ananth and Ian Pollick. Even then, the US central bank would not sell holdings of assets like mortgage-backed securities to avoid spooking the market.
It would also rollover roughly a third of its treasury holdings, they said.
Policymakers have debated ways to reduce one of the main drivers of the balance sheet’s growth: the banking sectors’ demand for cash held at the central bank.
Dallas Fed President Lorie Logan said last week she favours using changes in liquidity rules to shrink banks’ need to hold reserves, following similar calls from governor Stephen Miran and vice-chair of supervision Michelle Bowman.
A recent essay published by the Dallas Fed about ways the central bank can shrink its balance sheet understates the costs and risks of a rapid balance sheet reduction, said the CIBC strategists.
There are also some underlying issues that “aren’t immediately obvious”.
For starters, proposals like lowering bank reserves or offering tiered rates on bank reserve policies, would increase the importance of money market funds in the transmission of monetary policy.
The funds have been the primary vehicle for transmitting monetary policy to the market through the Fed’s overnight reverse repo facility.
That shifts some control over monetary policy actors to the Securities and Exchange Commission, which oversees mutual funds, from the Fed, they said. That could limit the banking regulators’ reach during a crisis.
“In times of extreme stress it can be useful to have strong regulatory control over the firms you are relying on for monetary policy passthrough,” they wrote.
CIBC said the Fed is unlikely to adjust interest on bank reserves or the offering rate on the reverse repurchase agreement facility, which means the forward spread between the Secured Overnight Financing Rate and interest on excess reserves is “a little too wide”, and the markets are mispricing short-term rates.
CIBC also highlights a timing mismatch: regulatory changes that reduce banks’ demand for reserves would take effect long before the Fed could adjust the asset side of its balance sheet, leaving policymakers uncertain for an extended period about how new policies are working.
The Dallas Fed essay also argues that if policymakers reduce demand for reserves by reducing the interest it offers for them they would create more aggressive bank borrowing and lending, pushing up rates and revive interbank markets that have become dormant.
But CIBC said a steep money market demand curve reflects the loss of the bank safety net, and without that backstop a supply‑demand mismatch in repo can “push up prices wildly”.
“Having a reserve scarcity will not create material benefits from building an active market,” they wrote.
“Given that two triggers are needed to cause a dramatic rate spike (scarce reserves and a supply/demand mismatch), it is almost impossible for the Fed to know precisely when it is crossing from ample reserves to scarce reserves.”
And while several proposals call for greater use of the Fed’s lending facilities including the discount window to reduce bank’s reserve needs, the strategists noted the stigma of such borrowing remains a legitimate reputational concern.
Expanding the list of eligible counterparties would also increase political risk for the central bank by exposing it to accusations that it stepped in to help a lender that was being shunned by private investors. — Bloomberg
