By Michael S. Derby
NEW YORK (Reuters) – The Federal Reserve’s effort to contract its balance sheet will likely run into 2025 before the process ends, with the endgame dependent on the financial system’s need for liquidity, the Federal Reserve Bank of New York said in a report released on Wednesday.
“Future financial and economic conditions and their impact on the demand for reserves and the balance sheet are highly uncertain,” the bank said in its annual report for the central bank’s System Open Market Account, which holds the Fed’s cash and bonds primarily to conduct monetary policy.
The Fed has been shrinking its bond holdings in a process called quantitative tightening, or QT, to reverse part of its massive asset buying begun at the onset of the coronavirus pandemic in the spring of 2020.
The aggressive purchases of Treasury and mortgage bonds, to stabilize markets and provide economic stimulus, led Fed holdings to more than double, topping out at $9 trillion by the summer of 2022. The QT process started later that year has brought Fed holdings down to about $7.5 trillion.
With the Fed’s campaign of rate hikes almost certainly completed, Fed officials and markets have been debating when the central bank can stop QT. Fed officials are mulling a plan to significantly slow the bond runoffs of up to $95 billion per month, in a bid to extend the overall process and reduce the risk of unsettled markets.
Fed officials have given no guidance about the QT stopping point, beyond saying they would like financial sector liquidity at a level that allows for normal volatility and affords the central bank firm control over its rate target. Major banks surveyed by the New York Fed ahead of the March Federal Open Market Committee meeting were eyeing a February 2025 stopping point, with Fed holdings at $6.25 trillion.
The New York Fed report said that if banks seek a higher reserve level the Fed may be able to slow QT in the first half of this year, with QT stopping in early 2025 at a $6.5 trillion balance sheet. Under a lower reserves need scenario, QT could taper off in the first half of 2025 and possibly end mid-year with the balance sheet at $6 trillion, the report said.
“These projections illustrate possible paths for the portfolio and reserves associated with the dynamics that will likely prevail in the coming years,” the report said.
Fed officials are watching a wide range of money market indicators to understand when liquidity levels are drawing tight and so far, they are not seeing any notable signs of scarcity in the financial system. Fed officials also believe there are no hard and fast metrics that will signal tightening liquidity.
As Fed officials move toward the end stages of QT they are doing so cautiously, so as not to repeat the end of the last period of QT, which saw the Fed withdraw too much cash from the financial system, spurring heavy market volatility.
LOSSES TALLIED
The New York Fed also reported on the outlook for its finances, revealing unrealized losses of $948 billion on its bond holdings last year. Net negative income that has led to a $163 billion paper loss so far, will continue through this year before the Fed expects to return to profitability next year.
Losses on Fed holdings do not affect Fed actions because the central bank is not selling its holdings. Meanwhile, Fed officials have stressed repeatedly the overall losses on operations do not affect their ability to accomplish the goals laid out for the central bank by Congress.
