(Reuters) – The head of the Federal Reserve Bank of New York on Tuesday brushed aside concerns that the central bank may once again be forced to end its large-scale reserve reductions early due to falling reserves in the banking system.
“I don’t agree with that concern,” New York Fed President John Williams said in an interview with the Wall Street Journal. He had been asked whether the decline in bank reserves held at the Fed over the past year portends a repeat of the market woes seen in 2019 as its balance sheet reduction program, known as quantitative tightening, or QT, shifts into high gear.
As head of the New York Fed, Williams oversees the open market operations critical to implementing the central bank’s monetary policy.
In 2019, the central bank was forced to abruptly end its first QT effort when those reserves — which act as one of the key offsetting liabilities on its balance sheet — fell too far. That caused a lack of liquidity in the $2.2 trillion repo market, which underpins much of the US financial system, and caused short-term borrowing costs to rise.
The Fed had to inject money to stabilize the market in its first major intervention since the financial crisis.
The Fed launched its second QT offering in June, aiming to right-size a balance sheet that had grown from $4.2 trillion at the start of the coronavirus pandemic to about $9 trillion. The QT effort is set to ramp up next week, when the monthly reduction target doubles to $95 billion.
This expected acceleration has raised concern that the outflow of deposits from banks to money market funds could also reduce bank reserves at such a rapid rate that it could hamper lending activities in financial markets and the broader economy. Even before the QT hike, bank reserve balances at the Fed have fallen to about $3.2 trillion from about $4.2 trillion a year ago.
Williams said the deployment of the overnight reverse repurchase program (ONRRP), which the Fed designed to help offset bank reserve declines and is largely used by money market funds, should guard against an unwanted effect.
“I see the ONRRP as a big safety net for us as we reduce the size of our balance sheet,” Williams said. “I think it makes it easier. It allows two different parts of our financial system to adjust our balance sheet liabilities as we reduce our balance sheet assets. That works great.”
He added that short-term interest rates were right in the target range and that there had been “very good” stability in those markets.
“I expect going forward that we’ll see reductions in both reserve and ONRRP balances over time. And that will happen depending on how the adjustment process works, but it’s working well and I expect that to continue,” Williams said.
At about $5.7 trillion, combined ONRRP and bank reserve liabilities are little changed from last year and have increased since April as the ONRRP balance has ballooned to nearly $2.5 trillion.
The issue of adequate bank reserves and how far QT can go has been a central point of discussion, including at last weekend’s annual symposium in Jackson Hole, Wyoming, hosted by the Kansas City Fed. However, it is not the only question about the prospects for QT.
Separate research by the Kansas City Fed and the Atlanta Fed earlier this summer concluded that pressures in the U.S. market could complicate the central bank’s plans to reduce its balance sheet by amplifying the effect of those cuts on financial markets and increasing interest rates more than expected.
Meanwhile, Williams was also asked to address the lack of progress in draining mortgage-backed securities from the Fed’s balance sheet: net MBS holdings are actually slightly higher than they were at the start of the program in early June, while Treasury holdings are down by about $70 billion.
Williams noted that the pace of reductions depends on market conditions, and with interest rates higher, fewer people are refinancing.
“This market takes a little time to get things going…we’re doing exactly what’s indicated and any week-to-week variances are really just more technical factors.”
(Reporting by Lindsay Dunsmuir and Dan Burns; Editing by Andrea Ricci)