“This action represents a necessary step that serves to fix the reserve hole the Fed dug itself into by continuing QT for too long and should firmly place the Fed back into an ‘abundant reserve regime'”, BofA’s Mark Cabana wrote Friday, in the wake of the announcement that the Fed would begin purchasing T-Bills next week at an initial pace of $60 billion/month.
The announcement was overshadowed by the unrelenting flow of news that bombarded market participants on Friday, a day that found the Trump administration effectively admitting that a series of “limited” agreements with China on trade may be all that’s feasible.
The unveil of the parameters around so-called “organic” balance sheet growth was immediately swamped by political and trade headlines, but it marked a crucial turning point in Fed policy.
Read more: ‘QE Lite’ Is Here! And It Starts Next Week…
What changed in September is that the Fed learned how easy it is to misjudge the threshold for reserve scarcity – how hard it is to observe the unobservable, if you will.
“Some banks maintained reserve levels significantly above those reported in the Senior Financial Officer Survey about their lowest comfortable level of reserves rather than lend in repo markets”, the September FOMC minutes read. “Money market mutual funds reportedly also held back some liquidity in order to cushion against potential outflows”.
Those passages underscored the futility of trying to measure reserve adequacy. “Attempts to measure where reserve scarcity kicks in were always doomed to fail, though hindsight is always 20/20”, BMO’s Jon Hill wrote, in a note out following the release of the minutes on Wednesday.
BofA’s Cabana on Friday described the Fed’s aggressive response (the $60 billion/month initial pace means they are front-loading the effort to back away from the upward-sloping part of the reserve demand curve and reestablish a buffer, rather than slow-walking it) as a “rapid shift away from repo operations to permanent balance sheet growth”. He also touts the details of the plan as “confirmation that the Fed shares our view that funding pressures were driven by ‘reserve scarcity’ vs ‘reserve distribution’ issues”.
Looking ahead, Cabana says Fed purchases could end up totaling $400 billion by mid-2020, which he notes would restore the level of reserves in the system to roughly $1.7 trillion.
Importantly, that would also mean the Fed could eventually convert outstanding TOMOs to permanent reserves in the course of reestablishing a buffer sufficient to cope with the kind of weekly swings which helped precipitate last month’s money market turmoil.
As we wrote on Friday, the extension of temporary OMOs through January gives the Fed more time to iron out the details of a standing repo facility. For his part, Cabana says the reserve increase telegraphed by the Fed obviates the need to introduce a standing facility at least in the near-term. The Fed now has “time to work out details of that facility which we think could be announced by end-2020”, he says.
Goldman weighed in briefly in a Friday evening note. “Assuming bills are purchased at this pace from mid-October to mid-April at the very least, this should expand the Fed’s balance sheet by about $360 billion over that time frame”, the bank said, adding that the plan “should also expand reserves by about $300 billion, all else being equal, which would over time take the total amount above the early September 2019 level (~$1.5tn) the Fed appears to be benchmarking itself to”.
How the Fed communicates around any rate cut later this month will be key. It’s possible (indeed, it’s likely) that the Fed saw more than a little utility in announcing balance sheet expansion separately.
Not only does the Fed now have an early start (albeit after being too late to avert September’s wake-up call repo squeeze) versus the expected November launch, keeping the announcement distinct from the policy statement and Powell’s press conference may help make the case that this but a “technical” matter that “regular” market participants need not concern themselves with.