Fed may have to slow or stop balance sheet trimming in 2023, Barclays says

NEW YORK, Oct 20 (Reuters) – The Federal Reserve may need to slow or halt the shrinking of its nearly $9 trillion balance sheet sooner than many are now expecting, according to a report by Barclays.

Analysts at the investment bank wrote this week that the current pace of the decline is likely to change in the first half of next year. Because if the Fed pressed to shrink its balance sheet, bank reserves would fall to levels by the end of 2023 that would make it more difficult to maintain firm control of the Federal Funds Rate, the Federal Reserve’s primary influencing tool Business.

So far, Fed officials have offered little guidance as to how long and how far they intend to go with cutting inventory, merely indicating that they view it as a lengthy process with an uncertain conclusion. “I don’t know what the ultimate end point of our balance sheet is,” Minneapolis Fed President Neel Kashkari said Wednesday, but “we still have a long way to go.”

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This final stage of the process is difficult due to a number of factors. The main uncertainty, however, is that it is unclear when the financial system will move from ample bank reserves to levels where they are scarce.

Tight reserves mean the federal funds rate can become volatile, which central bankers don’t like. When reserves ran low in September 2019, the Fed had to step in to prop them up through asset purchases and temporary liquidity injections.

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Barclays’ analysis comes as the Fed tightens monetary policy on two fronts. His attempt to lower inflation, which has hit 40-year highs, is driving officials to aggressively increase their federal funds interest rate spread, with hikes likely to spill over into next year.

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Withdrawing stimulus also meant shrinking the Fed’s balance sheet. From a size of $4.2 trillion in March 2020, stocks peaked at around $9 trillion last spring on stimulus efforts to buy bonds related to the coronavirus pandemic. The Fed began cutting inventories by $95 billion a month in September, with inventories now at $8.8 trillion. Amid this decline, bank reserves have fallen.

The Barclays report states that due to changes in the financial system, aggregate reserves are likely to come under pressure at higher levels, meaning that “current levels of bank reserves are likely closer to reserve constraint than they might have been prior to 2015. “

The path the Fed is on right now is likely to take just over $1 trillion off its balance sheet over the next year, meaning reserves will become an issue for monetary policy before the end of the year, the in said the report.

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“In our view, these changes in the shape and location of the bank reserve demand curve will result in the Fed reaching ‘sufficient’ much sooner than expected,” the report said.

The Barclays report concedes that the Fed could tweak the settings of its interest rate control toolkit or resort to other measures that could give it some leeway on the reserve issue. But such things only offer temporary respite, making changing the pace of balance sheet deleveraging a more valuable tool.

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Reporting by Michael S. Derby; Adaptation by Dan Burns and Paul Simao

Our standards: The Thomson Reuters Trust Principles.

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