The official responsible for implementing Federal Reserve monetary policy said in a speech on Wednesday that the recent announcement to slow the pace of contracting the central bank balance sheet reduces the prospect of market stress, in remarks that also laid out metrics for measuring when liquidity might be becoming too scarce.
At the last Federal Open Market Committee meeting the Fed announced it would allow Treasuries to run off its holdings at a slower pace. The Fed has since the summer of 2022 been allowing its holdings to contract as part of a broader effort to make monetary policy more restrictive.
From the onset of the coronavirus pandemic in the spring of 2020 the Fed doubled the size of its holdings to $9 trillion on very aggressive buying of Treasury and mortgage bonds. It’s been allowing up to $95 billion to run off each month, which has taken Fed holdings down to $7.5 trillion. At the FOMC meeting officials said the cap on Treasury bonds' runoff would move from $65 billion to $25 billion. Chair Jerome Powell said he expects this new formula to result in around $40 billion per month in balance sheet reduction.
The Fed is trying to drain enough liquidity from the financial system to allow for normal money market volatility and firm control over the federal funds rate, its chief lever to influence the economy’s momentum. In slowing the pace of the drawdown, the Fed is also trying to avoid the events of September 2019, when markets endured unexpected stress during the last chapter of balance sheet reduction.
In his remarks, Perli said the final destination for the Fed’s balance sheet remains unknown right now. A recent New York Fed report suggested Fed holdings may fall to between $6 trillion to $6.5 trillion based on the market’s demand for bank reserves.
He also offered some guideposts for how the Fed is watching markets for signs liquidity is tightening in a way that would call for an end to what’s commonly referred to as quantitative tightening, or QT.
Perli said he’s watching “domestic bank activity in federal funds, the timing of interbank payments, the amount of daylight overdrafts, and the share of repo volume trading at or above the [interest on reserve balances]” rate.
