By Michael S. Derby
NEW YORK (Reuters) -The Federal Reserve faces no imminent market liquidity challenges that could stop the ongoing contraction of its balance sheet, according to a new tool launched Thursday by the Federal Reserve Bank of New York.
The new gauge, which the bank calls Reserve Demand Elasticity, seeks to measure how liquid bank reserves, a key aspect of financial sector liquidity, are. The bank said the new measure will help Fed officials better manage the uncertain process of cutting their holdings of bonds, in a process called quantitative tightening, or QT.
The new tool is designed to serve as an early warning indicator of impending reserve scarcity. The bank said in a blog posting that the measure will help spot the transition point between abundant levels of liquidity, toward the “ample” but undefined level of reserves policymakers say they are aiming for.
As of data available on Oct. 11, the measure indicates “reserves remain abundant. These latest RDE estimates are indistinguishable from zero, meaning that the federal funds rate does not significantly respond to shifts in reserve supply.” For reference, negative RDE readings suggest tighter liquidity.
The QT process has been running for a little over two years, with the Fed contracting the overall size of its holdings from a peak of $9 trillion to the current level of $7.1 trillion. The Fed is seeking to withdraw unneeded liquidity as part of an overall normalization of monetary policy in the wake of the coronavirus pandemic.
The Fed wants to make sure there is enough liquidity in the financial system to allow it firm control over the federal funds rate, its chief monetary policy tool to influence the economy. The challenge for Fed officials is that it’s unclear the point at which point liquidity becomes too scarce and money market rates become too volatile.
Earlier this year, the Fed slowed the pace of QT to make it easier to identify any looming liquidity challenges before they manifest themselves. Officials are mindful of the last QT process that saw liquidity run unexpectedly short in September 2019, forcing the central bank to intervene to add liquidity back to the market.
Fed officials say they expect QT to run for some time, and market participants ahead of the Fed’s September policy meeting eyed a spring stop to the process.
But money market turbulence at the end of September just ahead of the move into the fourth quarter was high enough that some in the market speculated the Fed might need to end QT early, although in comments on Oct. 7 St. Louis Fed leader Alberto Musalem noted "there's been good control" of the fed funds rate for some time, suggesting the recent volatility was not a major issue for the QT outlook.
So far, the process of shrinking Fed holdings has largely come on the back of draining cash out of the central bank's reverse repo facility, which has come down substantially over the course of this year.
Meanwhile, banks' collective reserve levels have been little changed for an extended period and until they start to fall, most observers reckon the Fed will be able to continue with QT.
In the blog posting, the New York Fed noted that negative readings at what became increasingly high confidence levels started well ahead of the September 2019 trouble, suggesting their new measure could help officials know well in advance when they might face the sort of reserve scarcity that would challenge control over the federal funds rate.
Ahead of the New York Fed announcement, analysts at investment bank Barclays said "we expect bank reserves will remain just above the ample threshold at year-end." They continue to expect QT to end this year, ahead of where many other traders and investors reckon.
The New York Fed said it will update on 10 a.m. ET on the third Thursday of every month, with exceptions to deal with Federal Open Market Committee meeting dates.