Federal Reserve QT and Bank Reserves: A Wall Street Perspective

Federal Reserve Governor Christopher Waller indicated last week that the Fed could reduce bank reserves from the current level of around $3.34 trillion to about $2.7 trillion, thereby continuing to shrink its balance sheet, a process known as “quantitative tightening” (QT).

However, JPMorgan strategists stated this week that the level of “ample reserves” needed to avoid disrupting overnight funding markets might need to be higher. Citigroup strategists Jason Williams and Alejandra Vazquez also stated on Monday that bank reserves could fall to $2.8 trillion by year-end.

Wall Street Thinks Bank Reserve Levels Should Be Higher at QT End

Market participants are closely watching the amount of cash that banks keep at the Fed to determine when balance sheet reduction should stop. With Congress now having raised the debt ceiling, Wall Street is closely monitoring for signs of rising Treasury cash balances – which would drain excess liquidity from the financial system, potentially making the market more vulnerable to sudden shocks (like the banking crisis two years ago).

“Given the March 2023 regional banking crisis (which showed the risk of deposit outflows reaching a peak) and the current regulatory framework’s high emphasis on liquidity, the threshold for ‘ample reserves’ may need to be higher,” JPMorgan strategist Teresa Ho, et al wrote in a July 11 note to clients.

The New York Fed’s June “Survey of Market Participants” showed a median expectation for reserve balances at the end of QT of $2.875 trillion.

The Fed has been shrinking its balance sheet since June 2022. In April of this year, policymakers slowed the pace of reduction: reducing the monthly cap on Treasuries allowed to mature without being reinvested from $25 billion to $5 billion, while keeping the cap on mortgage-backed securities (MBS) steady at $35 billion.

Policymakers’ core objective is to avoid a repeat of the September 2019 repo market turmoil. During the Fed's balance sheet reduction period at that time, a shortage of reserves led to a spike in key lending rates, creating anomalies in the federal funds rate and ultimately forcing the Fed to intervene to stabilize funding markets.

Speaking at the Dallas Fed last week, Waller mentioned that the ratio of reserves to GDP fell below 7% in September 2019, while at 8% in January 2019, there was “no apparent stress” on the banking system. Waller now believes it is necessary to maintain a buffer, setting the “shortage threshold” for the reserves-to-GDP ratio at 9% - below which reserves may be insufficient.

The Impact of Quantitative Tightening on the Economy

Quantitative tightening impacts the economy by withdrawing liquidity and reducing the money supply. This can lead to higher interest rates and reduced lending, potentially slowing economic growth. However, it can also help to curb inflation.

Monitoring Reserve Levels

Monitoring reserve levels is crucial for assessing the impact of quantitative tightening and determining when the Fed should halt or change course. Understanding these dynamics can help investors and businesses make informed decisions.