The Federal Reserve is on the verge of achieving a soft landing for the U.S. economy, a rare feat, as it navigates the delicate task of reducing cash in the financial system without unsettling markets. The Fed has already withdrawn approximately $1.4 trillion in its effort to wind down pandemic-era support by shrinking its balance sheet. The focus now shifts to determining the optimal time to halt this process, amid concerns that falling below a certain level of banking system reserves could lead to market disruptions.
Last week, Fed Chair Jerome Powell indicated that the central bank is close to deciding on slowing the pace of quantitative tightening (QT) to ensure reserves reach a comfortable level. Powell highlighted that the Fed is monitoring various indicators in the money markets to gauge when it is nearing this point.
Wall Street finds solace in the Fed's attention to this matter, despite the inherent challenges. Transitioning from "abundant" to "ample" reserves without causing scarcity is a complex task, made more difficult by the unclear signals from the market. Among the indicators under watch are bank reserves, certain key interest rates in money markets, and the volume of cash in the Fed's overnight reverse repurchase agreement facility.
Mark Cabana, head of U.S. rates strategy at Bank of America, believes the Fed has a good chance of executing a soft landing, maintaining appropriate reserve levels in the banking system, especially with its current accommodative stance. He expects the Fed to announce a tapering in May, halving the monthly cap on Treasury offloads to $30 billion, a view shared by John Velis, Americas macro strategist at BNY Mellon.
Correctly managing the drawdown is crucial as insufficient reserves could lead to abrupt rate increases, disrupt Treasury markets, and complicate funding for firms. This balance will be tested in the coming weeks with events like the April 15 tax day reducing cash in the financial system while increasing demand for it. However, market functioning has remained stable so far.
In 2019, a spike in short-term funding rates compelled the Fed to reintroduce reserves into the system, a situation Powell has expressed a desire to avoid, despite having established a backstop for money markets since then.
Current estimates suggest that the banking system requires between $2.5 trillion to $3.3 trillion in reserves, with the total presently around $3.5 trillion. Despite this seeming abundance, the need for cash among banks has grown, partly due to increased reserves following deposit outflows after bank failures in March 2023 and unrealized losses in securities portfolios. The distribution of reserves among banks varies, complicating the determination of sufficient levels.
Money market indicators watched by the Fed include the Fed funds rate and the Secured Overnight Financing Rate (SOFR) compared to the interest on reserve balances (IORB) the Fed pays to banks. Cabana anticipates the Fed aims for the Fed funds rate to be slightly higher than current levels and the SOFR to increase by 10-15 basis points, indicating that system cash is nearing ample levels.
