Daily Management Review

According To Barclays, The US Fed May Have To Slow Or Stop Balance Sheet Reductions In 2023


According To Barclays, The US Fed May Have To Slow Or Stop Balance Sheet Reductions In 2023
According to a Barclays report, the US Federal Reserve may have to slow or stop shrinking its nearly $9 trillion balance sheet sooner than many now expect.
Analysts at the investment bank wrote this week that the current rate of drawdown will most likely need to change in the first half of next year. Because if the Fed continues to allow its balance sheet to shrink, bank reserves will fall to levels that will make maintaining firm control of the federal funds rate, the US central bank's primary tool for influencing the direction of the economy, difficult by the end of 2023.
So far, Fed officials have provided little guidance on how long and how far they intend to reduce their holdings, stating only that they see it as a lengthy process with an uncertain end. "I'm not sure where our balance sheet will end up," Minneapolis Fed President Neel Kashkari said, adding that "we have a long way to go."
A number of factors contribute to the process's end state being difficult. The biggest uncertainty, however, is when the financial system will transition from abundant levels of bank reserves to scarce levels.
Because of the scarcity of reserves, the federal funds target rate may become volatile, which central bankers dislike. When reserves ran low in September 2019, the Fed was forced to intervene by buying assets and injecting temporary liquidity.
The Barclays analysis comes as the Fed tightens monetary policy on two fronts. Its attempt to reduce inflation, which has been running at 40-year highs, is causing officials to aggressively raise their federal funds target rate range, with increases likely to spill over into next year.
Withdrawing stimulus has also resulted in a reduction in the size of the Fed's balance sheet. The holdings increased from $4.2 trillion in March 2020 to around $9 trillion last spring as a result of bond-buying stimulus efforts related to the coronavirus pandemic.
As of September, the Fed began drawing down its holdings by $95 billion per month, bringing total holdings to $8.8 trillion. Bank reserves have been declining in tandem with this decline.
According to the Barclays report, total reserve levels are likely to come under pressure at higher levels due to changes in the financial system, which means "the current level of bank reserves is probably closer to reserve scarcity than might have been the case before 2015."
According to the report, the Fed's current path will likely shave off just over $1 trillion from its balance sheet next year, implying that reserves will become an issue for monetary policy before the end of the year.
"Our sense is that these changes to the shape and location of the demand curve for bank reserves will mean that the Fed reaches 'ample' much sooner than it expects," hitting that mark in the first half of 2023, the report said.
According to the Barclays report, the Fed could tweak the settings of its rate control toolkit or resort to other measures to buy time on the reserves issue. However, such measures only provide a temporary reprieve, making changing the rate of balance-sheet drawdown the more valuable tool.