The Fed's balance sheet: How much further can QT run?

Summary

• The FOMC looks to be near, if not already at, the end of its rate hiking cycle. However, policy tightening is likely to continue in the coming months as the Fed shrinks its balance sheet, a process known as "quantitative tightening" (QT).

• Since the Fed stopped reinvesting securities on its balance sheet in June of last year, the central bank's assets have shrunk by roughly $1 trillion to $7.9 trillion at present. The lion's share of the reduction has been through lower holdings of Treasury securities (down $841 billion), while mortgage-backed securities (MBS) have fallen by $228 billion. Partially offsetting these declines has been a rise in lending related to the emergency programs created in response to regional bank failures in March.

• A reduction in assets must be matched by an equivalent decline in liabilities. The primary channels for shrinking liabilities via QT occur through bank reserves and reverse repurchase agreements. Since QT began, bank reserves have fallen by a scant $17 billion. By far the biggest reduction on the liability side of the Fed's balance sheet has been reverse repurchase agreements (RRPs), which have plunged by $728 billion.

• How much longer is QT likely to continue, and how large could the Fed's balance sheet be when it ends? The answer largely boils down to the outlook for the U.S. economy, the stickiness of RRP balances and what the Fed considers an "ample" level of reserves. Below is our base case, predicated on our forecast for the U.S. economy falling into a modest recession in Q2-2024, as well as three non-recession, alternative scenarios.

  • Macro Forecast Base Case: A recession next year leads the Fed to cease QT at the start of Q3-2024. The Fed's balance sheet levels off around $7.2 trillion.

  • Non-Recession Alternative Scenarios

    • Sticky RRP Balances: Overnight reverse repurchase agreements (ON RRP) remain near their current level of about $1 trillion, and as a result bank reserves drain relatively quickly in the coming months. The FOMC slows QT in Q3-2024 and stops it completely at the end of 2024; the Fed's balance sheet recedes to $7 trillion or so.

    • RRP Back to Pre-Pandemic Level: ON RRP balances shrink back to essentially zero and bank reserves drain more slowly. The FOMC slows QT in Q3-2025 and stops it completely at the end of 2025; the balance sheet declines to about $6 trillion.

    • RRP Middle-of-the-Road: ON RRP balances decline to about $500 billion, roughly the halfway point between their current level and zero. The FOMC slows QT to start 2025 and stops it completely at the end of Q2-2025; the balance sheet falls to approximately $6.5 trillion.

• We see the level of bank reserves as the key driving force in determining the "equilibrium" size of the balance sheet. In light of the 2017-19 QT episode, we assume that reserves of around 8% of GDP is when the balance sheet reaches "equilibrium."

• The research literature suggests that the runoff associated with our "middle-of-the-road" scenario is roughly equivalent to a sustained 50 bps increase in the fed funds rate. All else equal, this implies a 50 bps-higher 10-year Treasury yield and adds to a variety of other factors also putting upward pressure on longer-term yields.

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