The Federal Reserve announced that starting next month, it will reduce the pace of its balance sheet drawdown due to ongoing challenges related to lifting the government’s borrowing limit. This adjustment is expected to persist for the duration of the process.
This decision was made during a Federal Open Market Committee meeting that kept the central bank’s interest rate target unchanged, as officials navigate significant uncertainty and a declining public sentiment regarding the economic outlook, influenced by the turbulent policy changes enacted by the previous administration.
Hints about a change in the balance sheet drew attention in the minutes from the January FOMC meeting, released last month. Fed Governor Christopher Waller, who has occasionally disagreed with his colleagues on managing the central bank's asset holdings, opposed the decision to adjust the balance sheet drawdown.
As part of this reduction in quantitative tightening, the monthly cap for maturing Treasuries that will be allowed to roll off without replacement will decrease from $25 billion to $5 billion, starting April 1. Meanwhile, the cap for mortgage-backed securities will remain at the current $35 billion limit.
In the lead-up to the Fed meeting, several banks anticipated some changes to quantitative tightening based on the meeting minutes, though many expected any shift would be temporary due to the potential for transitory government cash management issues.
Fed Chair Jerome Powell, in a post-meeting press conference, indicated that the slower pace of drawdown would remain in place and contribute to a smoother conclusion of quantitative tightening. He noted that officials were largely in favor of this adjustment, which may extend the duration of the QT process before a halt is necessary.
Some market participants interpreted the slowdown in QT, primarily affecting Treasuries, as a softer approach to halting it altogether. ING's Chief International Economist, James Knightley, described the change as significant news, questioning why the Fed did not opt for a complete cessation, aside from avoiding a narrative that would suggest an end to QT in Treasuries.
When asked why the Fed did not also slow the drawdown for mortgage-backed securities, Powell mentioned that such a change might occur in the future. Throughout the QT process, the Fed has struggled to reach its cap for this type of security due to a sluggish housing market, characterized by slow mortgage creation and limited refinancing activity amid rising rates.
Powell expressed that officials aim for mortgage-backed securities to gradually roll off the balance sheet, emphasizing that even when they reach a point of wanting to maintain their holdings, they might still allow these assets to expire without replacement.
The QT process, initiated in 2022, aims to remove the excess liquidity injected into the financial system during the COVID-19 pandemic and its immediate aftermath. The Fed had aggressively bought Treasury and mortgage bonds, significantly increasing its balance sheet to a maximum of $9 trillion. So far, QT has reduced the balance sheet by over $2 trillion, and officials suggest there is still ample liquidity in the system, allowing for further progress in the tightening process.
A recent complication in the QT strategy is the debt ceiling, which restricts the government's borrowing capacity. In light of this, the Treasury has been utilizing cash from its account at the Fed to meet obligations, thus adding liquidity to the system. Once the debt ceiling is lifted, the Treasury is expected to replenish its account, which will remove liquidity from the market.
During this period, Fed officials may struggle to gauge the true state of market liquidity. This uncertainty complicates their ability to assess whether they are removing too much liquidity, as an excessive withdrawal could destabilize financial markets, reminiscent of the QT experience in September 2019.
In general, slowing QT provides the Fed with the flexibility needed to manage the process effectively. Some analysts believe that this pause could enable the central bank to progress further with the drawdown, a perspective that Powell seemed to support.