Fed balance-sheet reduction means trouble in 2023, Barclays says

The Federal Reserve early next year will need to put the brakes on the process of shedding some of the roughly $4 trillion of U.S. Treasury and mortgage bonds added to its balance sheet starting in March 2020.

That’s the prediction of Barclays Plc analysts, who say that draining reserves from the banking system by effectively returning securities to the private market will reach a practical limit during the first quarter.

Banks have about $3 trillion of reserves parked at the Fed. While the Fed’s balance sheet is on pace to shrink by less than $500 billion by year-end, other factors will contribute to reserves falling to $2.1 trillion during the first quarter of 2023.

At that level, financial institutions are likely to start to compete more aggressively for deposits, the effect of which would be to push short-term interest rates higher, including the effective fed funds rate targeted by U.S. monetary policy. As an offset, the Fed could curtail its overnight reverse repurchase facility, where a shortage of Treasury bills has caused daily balances to routinely exceed $2 trillion in the past two months.

Tapering balance-sheet reduction “makes more sense than forcing money out of the RRP since it would allow markets time to adjust and pull money out of the program voluntarily,” Barclays strategist Joseph Abate and economist Jonathan Millar wrote in a report. “It also means that banks would not need to adjust their deposit rates abruptly and keep bank lending rates from tightening financial conditions too sharply.”

The Fed started its so-called quantitative tightening program in June by replacing its maturing Treasury and mortgage-bond holdings only in excess of a monthly runoff cap. Beginning in September those limits are set to increase to maximum levels of $60 billion and $35 billion per month, respectively.