Wednesday, February 06,
2019 12:25 PM / Fitch Ratings
The size of the Federal Reserve's balance sheet is likely to continue falling through 2020 despite the Federal Open Market Committee's (FOMC) new forward guidance on balance-sheet normalization, Fitch Ratings says. The decline in the Fed's balance sheet from current levels will be smaller than we previously forecast, but given that the ECB has ended quantitative easing (QE) purchases and the Bank of Japan is tapering its balance-sheet expansion, global quantitative tightening is here to stay.
The Fed's announcement last week that normalization would be completed sooner and at a larger size than it previously estimated accompanied other messages that were surprisingly dovish, notably the removal of forward guidance that further rate increases would be warranted. But the balance-sheet announcement did not reflect decisions about the monetary policy stance. Moreover, Fitch's analysis suggests that the Fed's balance sheet will continue declining through 2020.
Fed Chairman Jerome Powell devoted half of last week's press conference opening statement to the announcement that the Fed would maintain the 'floor' system for setting interest rates indefinitely. This has implications for the long-run size of the balance sheet because the floor system (which since 2008 has set an administratively determined interest rate by paying banks the policy interest rate on their reserve balances at the Fed) requires the Fed to provide the banking system with sufficient reserves to saturate demands for overnight liquidity. Without abundant overnight liquidity, banks could bid for overnight funds in the interbank market, driving interest rates above the policy rate.
Under its pre-2008 framework, the Fed did not pay interest on reserves and controlled rates indirectly by maintaining reserves at very low levels and varying reserve supply daily. This kept the market clearing price of overnight liquidity in line with the Fed funds target policy rate.
The fresh commitment to the floor system elevates the importance of regulatory changes that have sharply increased US banks' demand for overnight liquidity. Banks must now hold high-quality liquid assets (HQLA) - which include reserves at the Fed - to meet minimum liquidity coverage ratios. HQLA rules may see some changes which reduce reserve demand from smaller banks, but this is unlikely to substantially change overall demand.
It is hard to specify the level of reserves sufficient to ensure abundant liquidity. One guide is a recent Fed Survey of Senior Financial Officers, which asked a sample of banks how far reserves could fall before they started taking steps to raise them. The answer was 45% of September 2018 levels (when aggregate reserves were USD1.9 trillion). Using this as a proxy for the point where banks may start to bid up overnight rates beyond the policy rate suggests aggregate reserve levels of about USD850 billion to ensure abundance. Earlier Fed research published in 2017 assumed long-run equilibrium reserve levels of USD100 billion.
The Fed's normalized long-run balance sheet also has to accommodate demand for physical currency for transaction purposes. The stock of currency outstanding was USD1.7 trillion at end-2018 and is likely to continue growing by about 4% a year. The Fed's other non-reserve liabilities were about USD700 billion and will probably remain broadly stable over the medium term. In combination, these assumptions suggest a normalized balance sheet of about USD3.2 trillion, rising to USD3.3 trillion over the next couple of years as currency demand grows.
On this basis the Fed's balance-sheet normalization would be complete by late 2020. The current monthly rate of decline in the Fed's assets is capped at USD50 billion but actual maturities will be lower with assets declining by USD430 billion through 2019 and USD320 billion through 2020. Hence it would take just under two years to bring the Fed's balance sheet down to our new estimate of its normalized value (scenario 2). This is two years earlier than in previous Fitch projections published in 2017, when we assumed commercial bank reserves would fall to USD100 billion and the overall balance sheet to a normalized value of USD2.7 billion by end-2022 (scenario 1).