Impact of Fed Balance Sheet on Money Supply

Liquidity is a crucial yet often misunderstood macro variable. The Fed has been running QT for a while and yet there is still abundant liquidity in the financial system. Fed’s bond holdings are down $1.3 trillion from their peak (due to QT), yet only half of this supposed tightening has actually impacted bank reserves (aka ‘’liquidity’’) which are down a meagre $0.7 trillion. This ongoing ‘’money mystery’’ has caught many off-guard in 2023, and liquidity developments could be surprising in 2024 as well. Back in 2021 the Fed had an issue: rates were at 0%, and there was too much money in the system. Money Market Funds (MMF) were bidding up T-Bills so much that yields were testing negative levels (!), and so to stabilize money market rates the Fed proposed a friendly alternative: the Reverse Repo Facility (RRP). This encouraged MMF to park money at the Fed, and they did in huge size: the RRP reached $2.5 trillion. You can think of this like pent-up ‘’liquidity’’ stored in a corner of our financial system.  But here is the thing. In 2023 MMF have unleashed this pent-up force: the RRP usage has dropped materially, and this wave of supportive ‘’liquidity’’ has been thrown at markets. Specifically, MMFs drained down their huge RRP balances and they bought T-Bills the US government issued to roll-over debt. The marginal bid absence in bond markets from the Fed doing QT was (partially) replaced by money market funds buying T-Bills. The result is that QT didn't drain ‘’liquidity’’ from the banking system (orange) but the RRP picked up the slack instead. Today the RRP facility is significantly lower though, and as QT continues this ''sterilization'' effect might not work as well in 2024. This is already leading Fed members to discuss a slowdown in QT to avoid another blow-up in repo markets as the one we saw in 2019. Liked this analysis and you want access to my Institutional Macro Research? Ping me (Alfonso Peccatiello) on Bloomberg and I will set you up!

Contrary to our previous expectation held till last summer, that a bottoming out in the usage of the Fed’s reverse repo facility combined with a continuation of the Fed’s QT would induce a mildly contracting phase in US liquidity from April 2024 onwards, US liquidity kept expanding since August making new record highs. This expansion of US liquidity, which we proxy by the sum of the stock of US commercial bank deposits and the AUM of US money market funds (MMFs), has been driven by larger than expected issuance of US Tbills since the beginning of August, which in turn induced further decline in the usage of the Fed’s reverse repo facility by domestic counterparties. Cumulatively since May 2023, the US Treasury flooded the financial system with $2.2tr of Tbills inducing MMFs to reduce their reverse repos by a similar amount, thus creating both reserves and bank deposits. This massive injection of liquidity more than offset the $1.2tr liquidity contraction from the Fed’s QT, allowing the stock of deposits in the US banking system to expand rather than shrink over the same period. And this expansion in US bank deposits took place despite the $1.2tr US bank deposit shift to US MMFs since May 2023, helping the US banking system to avert a liquidity crisis post SVB. The rise in US liquidity is set to continue into 2025. Even if the Fed's QT does not end in March 2025 and continues through the end of 2025, we still believe that bank lending (which also creates money) bolstered by the potential policy mix of the new US administration, would be strong enough to offset next year’s QT.

Fed pivot or not, liquidity is on the rise again. Overall liquidity, as defined by the Fed’s balance sheet, less reverse repos (RRP) less the Treasury’s cash balance at the Fed (TGA), has been rising since mid-2023, taking stocks with it. As the Fed’s reverse repo program gets closer to being depleted (only $440 billion left), all eyes will be on how much longer the Fed’s Quantitative Tightening (QT) program will continue. The liquidity dynamics chart below shows the change in these three components of liquidity from the start of the Fed’s tightening cycle. Reverse repos have completely offset the Fed’s balance sheet contraction. If QT continues past the depletion of the RRPs, liquidity would be tightening again. At that point, it will be a matter of what level of bank reserves the Fed is aiming for. If it’s around $3 trillion, that would suggest a longer runway for QT (since reserves are now $3.6 trillion). For now, liquidity is growing again, not only per the above metrics, but also in terms of real rates and the money supply itself. In that sense, it’s no coincidence that gold is rallying again. Welcome to another era of fiscal dominance.

While most of the attention from the Fed meeting last week focused on the quarter point drop in the short-term Fed Funds Rate, Jerome Powell also announced an important change in monetary policy. The Fed will end its balance sheet reduction, starting on Dec 1. The Fed's strategic use of its balance sheet is controversial and esoteric. They have called it an emergency tool to add liquidity to markets, but in the last 20 years we've already had two emergency uses of this tool. The result is the balance sheet swelled from $1 trillion in 2008 to nearly $9 trillion in 2022. The Fed recognizes the economic risk of its large balance sheet and has been reducing its holdings over the past three years. However, reducing the balance sheet also carries risk, since it drains liquidity from the economy and the banking system. We're starting to see an increase in volatility in overnight lending markets. The last time we saw this was in 2019 - the last time the Fed tapered its balance sheet. The Federal Reserve has done a good job of bringing its balance sheet down more than $2 trillion, from $8.9 trillion to $6.6 trillion. But with a slowing labor market, sticky inflation, and tighter financial markets, its job is about to get much more difficult. https://lnkd.in/gFrBRA5k #economy #fed #monetarypolicy #interest #rates #balancesheet #repo