Federal Reserve Balance Sheet Reduction Unlikely to End Abruptly

Citi economists opine that it’s improbable the Federal Reserve will promptly announce an end to balance sheet reduction before September or sooner.

Previously, the bank noted that the Fed would probably halt balance sheet reduction before reserves reach a “somewhat above” ample level, especially if a recession occurs.

During the July 2023 press conference, Fed Chair Powell indicated that if conditions were stable and the central bank was simply working to normalize lower rates, balance sheet reduction could proceed even alongside decreasing policy rates.

However, this outlook might shift if there is significant weakening in the labor market and economic activity, according to Citi economists.

Recent jobs reports show more than expected labor market weaknesses, making it more likely that Fed policymakers may indicate at the September meeting that the end of balance sheet reduction is approaching, possibly by December.

They stated: “If activity and labor market data decline further in the upcoming weeks, an earlier conclusion to the balance sheet reduction could be communicated at the September meeting, but an abrupt conclusion in September isn’t our expectation unless acute liquidity challenges arise.”

Economists also mentioned they do not foresee major liquidity pressures shortly, given that reserves are still plentiful, reverse repo balances hover around ~ $290 billion, and the standing repo facility is available for support.

For the week ending July 31, the Fed’s balance sheet contracted by approximately $27 billion, including $10 billion in Treasuries and $14 billion in mortgage-backed securities.

On the liabilities side, the Treasury’s cash account (TGA) jumped to $854 billion by July 31 due to month-end settlements but has since decreased to $759 billion. The Treasury predicts that the TGA will reflect roughly $850 billion by the end of September, dropping to $700 billion by year-end when the debt ceiling suspension concludes.

Moreover, reverse repo (RRP) balances have remained more stable than anticipated despite rising SOFR rates, likely due to intermediary and counterparty limit issues. As a consequence, and in light of strong TGA liquidity, bank reserves fell to $3.178 trillion from $3.276 trillion during the same period.