Federal Reserve's Balance-Sheet Runoff May Face Volatility Amid Debt Ceiling Uncertainty
The ongoing debt ceiling impasse poses significant risks to the Federal Reserve's balance-sheet runoff, with potential consequences for money-market rates and volatility. According to Roberto Perli, a senior economist at the Federal Reserve Bank of New York, the prolonged delay in resolving the debt ceiling issue could lead to considerable volatility in money markets.
Debt Ceiling Impasse and Its Impact on the Fed's Balance-Sheet Runoff
The current standoff over the debt ceiling has forced the Treasury Department to implement special accounting measures and draw down its cash reserves to prevent a payments default. The level of outstanding US debt reached its statutory limit in January, prompting concerns about the potential consequences for the economy.
Perli emphasized that once the debt ceiling is resolved, the Treasury Department tends to rapidly rebuild its cash pile, resulting in a rapid decline in other liabilities. This could particularly affect bank reserves since the overnight reverse repo facility is "largely depleted." Perli's warning highlights the risks associated with the prolonged balance-sheet runoff and the potential for volatility in money markets.
Repo Pressures and the Need for Quantitative Tightening
The Federal Reserve has been shrinking its holdings of debt since June 2022, allowing up to $25 billion in Treasuries and $35 billion in mortgage-backed securities to mature each month without reinvesting the returned principal. The Fed's quantitative tightening (QT) process aims to reduce the central bank's balance sheet and ease monetary policy.
However, indicators show that reserve conditions remain abundant, and it is unclear at what point reserves will become scarce. Perli acknowledged that repo pressures have been gradually increasing, citing the increased share of interdealer market transactions taking place above the interest rate on reserve balances, which is notably higher than this time last year.
Portfolio Composition and Secondary-Market Treasury Purchases
The SOMA Treasury portfolio is currently "significantly underweight" bills and "significantly overweight" coupon securities with 10 to 22.5 years remaining to maturity, according to Perli. To address the discrepancy, he suggested allocating secondary-market purchases to T-bills at a gradual pace to avoid impacting the markets.
Federal Reserve Bank of Dallas President Lorie Logan, a former SOMA manager, advocated for purchasing more shorter-term securities than longer-term ones in the medium term to quickly mirror the composition of Treasury issuance. Perli emphasized that this strategy would not lock policymakers into a particular portfolio structure and would allow them to adjust and achieve any desired portfolio composition to best support their policy objectives.
Standing Repo Facility and Improving Efficacy
Perli acknowledged that the addition of a morning operation on the days spanning the end of the year may have contributed to a relatively smooth conclusion to 2024 in the funding markets. He also mentioned the possibility of offering a technical exercise at the end of March, another period when short-term rate markets tend to be volatile.
According to the latest FOMC minutes, several Fed officials supported looking for ways to improve the efficacy of the Standing Repo Facility. The New York Fed has been conducting a series of small-value exercises to take place at the beginning of the trading session.
Conclusion
The ongoing debt ceiling impasse poses significant risks to the Federal Reserve's balance-sheet runoff and potential consequences for money-market rates and volatility. Perli's warning highlights the importance of resolving the debt ceiling issue and implementing measures to mitigate the impact on the economy. The Fed must continue to closely monitor reserve conditions, repo pressures, and portfolio composition to ensure that its policies remain effective in supporting economic growth while maintaining financial stability.