Fed View: Powell is right when he says this is not QE – Fed Chair Powell caught headlines overnight after confirming that the Fed is about to begin regrowing its balance sheet as a long-term solution to the recent funding market problems. Powell had already clearly stated this in his post-FOMC press conference in September, and the only new information we gleaned from yesterday’s comments was that the regrowth of the balance sheet would be focused on the purchase of short-term Treasury bills rather than longer term bonds. This served to underline the distinction with quantitative easing – which had the specific goals of pushing down long-term rates through long-term bond purchases, and driving a portfolio rebalancing by over-supplying dollar liquidity. What the Fed now proposes to do is merely to meet – rather than exceed – demand for dollar liquidity. The effect on the stance of monetary policy should therefore be negligible.
Why do banks prefer holding cash to Treasuries? – The recent funding market pressures stem from higher demand for dollars than the Fed had guesstimated as it unwound its balance sheet over the course of 2017-2019. Indeed, demand for excess reserves is much higher than it was before the crisis. The primary reason for this appears to be the post-2008 Basel III and Dodd-Frank regulations, and in particular the liquidity coverage ratio (LCR) and resolution plan requirements. While it could be argued that Treasury securities are sufficiently liquid assets for these purposes, banks appear to be erring on the side of caution given the potential for market stress scenarios affecting the easy sale of these assets. Indeed, Fed Vice Chair for Supervision Randal Quarles has said ‘occasionally we hear that banks feel they are under supervisory pressure to satisfy their [requirements] with reserves rather than Treasury securities.’
Expect $150-200bn boost, followed by organic growth – As previously flagged, we expect the Fed to formally announce a decision on the balance sheet at the 29-30 October FOMC. The question is, by how much will the Fed need to regrow the balance sheet, and at what pace? Clues for this are provided by the continued repo operations that the NY Fed has conducted to address the liquidity shortage in the short term. While demand at these operations has fallen considerably, from a peak of $92bn in September to $30.8bn in today’s operation, the Fed will want to regrow the balance sheet at least by the maximum amount demanded at these operations, plus a buffer to be sure demand is sufficiently met. We therefore expect an initial boost of c.$150-200bn – with purchases conducted over a few months – followed by organic growth of the balance sheet in line with nominal GDP growth (to meet growing cash demand – as occurred prior to the financial crisis), i.e. c.4% p.a. In the meantime, the Fed will likely want to continue its repo operations until it judges the balance sheet has reached a level sufficient to cover reserve demand. (Bill Diviney)