The Fed may have to slow down or stop reducing its balance sheet in 2023, says Barclays – Business & Finance

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NEW YORK: The Federal Reserve may have to slow down or stop shrinking its balance sheet by nearly $9 trillion sooner than many now expect, according to a Barclays report.

Investment banking analysts wrote this week that the current pace of decline is likely to change in the first half of next year. Indeed, if the Fed were to apply pressure to allow its balance sheet to contract, bank reserves would, by the end of 2023, fall to levels that would make it difficult to maintain firm control of the federal funds rate, the the US central bank’s main tool for influencing the direction of the economy.

So far, Fed officials have given little guidance on how long and how far they plan to go in the asset cut, noting only that they see it as a protracted process heading towards an end. uncertain. “I don’t know what the end point of our balance sheet is,” Minneapolis Fed President Neel Kashkari said Wednesday, but “we have a ways to go.”

This end state of the process is tricky due to a number of factors. But the biggest uncertainty is that it is not clear when the financial system will move from high levels of bank reserves to one where they are scarce.

Scarcity of reserves means the target fed funds rate can become volatile, which central bankers don’t like. When reserves collapsed in September 2019, the Fed was forced to step in to bolster them through asset purchases and temporary liquidity injections.

Barclays’ analysis comes as the Fed is tightening monetary policy on two fronts. His bid to curb inflation, which is at 40-year highs, is pushing officials to aggressively raise the federal funds target rate range, with increases likely to spill over into next year.

US banks see $5tn in reserves built as recession risks rise

The withdrawal of stimulus also led to a reduction in the size of the Fed’s balance sheet. From a size of $4.2 trillion in March 2020, holdings peaked at around $9 trillion last spring due to stimulus efforts in bond buying related to the coronavirus pandemic. The Fed began cutting its holdings by $95 billion a month starting in September, with holdings now standing at $8.8 trillion. Amid this decline, bank reserves have shrunk.

The Barclays report said that due to changes in the financial system, total reserve levels are likely to come under pressure at higher levels, meaning that “the current level of bank reserves is likely closer to the scarcity of reserves that could not have been the case before 2015.”

The path the Fed is currently on will likely cut just over $1 trillion from its balance sheet next year, meaning reserves will become an issue for monetary policy before the end of the year. , according to the report.

“Our feeling is that these changes in the shape and location of the demand curve for bank reserves will mean that the Fed will hit ‘ample’ much sooner than it expects, hitting that mark in the first half of 2023, according to the report.

The Barclays report acknowledges that the Fed could change the settings of its rate control toolkit or resort to other measures that could buy it space on the reserve issue. But that sort of thing only offers temporary respite, which makes changing the pace of balance sheet reduction the most valuable tool.

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