The Federal Reserve may need to end its quantitative-tightening program early to preserve the amount of bank reserves in the financial system while also maintaining its hawkish signaling on interest rates, according to Citigroup Inc.
(Bloomberg) — The Federal Reserve may need to end its quantitative-tightening program early to preserve the amount of bank reserves in the financial system while also maintaining its hawkish signaling on interest rates, according to Citigroup Inc.
As Citigroup sees it, the Fed’s new Bank Term Funding Program, introduced over the weekend after the collapse of Silicon Valley Bank, will create additional reserves in the financial system to avert funding stress.
Essentially, that risks being seen as a form of quantitative easing at a time when the Fed is engaged in a major effort to do just the opposite: Since mid-2022, it’s been unwinding its massive pile of Treasury and mortgage-backed securities — aiming to ultimately remove trillions of dollars of excess liquidity from the financial system.
“Their new BTFP facility is QE in another name – assets will grow on the Fed balance sheet which will increase reserves,” Citi strategists Jabaz Mathai, Jason Williams and Alejandra Vazquez Plata wrote in a note to clients on Monday. “Although technically they are not buying securities, reserves will grow.”
As part of its move to combat soaring inflation and withdraw the unprecedented policy accommodation unleashed amid the pandemic, the Fed ramped up its so-called quantitative tightening to full speed in September. It’s now shrinking its bond portfolio by as much as $95 billion a month, while at the same time pursuing an aggressive campaign of interest-rate hikes.
For the Fed, an overarching concern is that it avoids pulling back too far on liquidity in the financial system as it tightens policy, creating strains in the markets where banks fund themselves.
Bank deposits have fallen since the Fed started its hiking cycle a year ago, spurring customers to shift cash to higher-yielding instruments. That has in turn forced institutions to increase rates on offerings like certificates of deposit more in line with Treasury bills and money markets to stem the exodus.
They’ve also been tapping wholesale funding markets for additional dollars. For example, the daily fed funds rate for borrowers in the 99th percentile in terms of volume, the entities that need those funds the most, has climbed since the end of 2022, Fed data show.
The longer QT goes on, “the more at-risk banks are of losing aggregate reserves in the system,” the Citigroup strategists wrote. “Deposit outflows should continue to be directional with reserves and it is very easy to see paths where reserves scarcity is hit later this year if the Fed wishes to keep all hawkish options on the table.”
Fed’s Choices
The strategists see three options for the Fed. One would be stopping QT early or reducing the monthly amount of bonds it allows to roll off, to ensure reserves are relatively stable for the rest of the year.
Another choice would be to lower the maximum amount each money-market fund is allowed to park at the Fed’s reverse repurchase agreement facility from $160 billion, while allowing QT to run in the background.
A third possible route, according to Citigroup, is that the Fed stops hiking but continues its balance-sheet unwind, forcing money funds to extend the weighted average maturity of their holdings and pulling cash out of the RRP as they buy longer maturities. The strategists see this as unlikely since the Fed has shown it’s more comfortable tightening economic conditions via short-end rates.
Still, it’s too early to determine how the Fed’s new facility will evolve and whether it will carry a stigma similar to the discount window and a Fed facility known as the Standing Repo Facility. In that case, the outflow of deposits may continue, pushing more cash into bigger banks and money funds, which may ultimately move it to the Fed’s reverse repo facility.
“While BTFP will likely support sentiment in the short-term and reduce any uninsured deposit flight, this is no guarantee that bank deposits will not shift into the RRP facility or leave to competing banks – thus risks remain on the table,” the strategists wrote.
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