New York Fed "hints" at withdrawing QT roadmap: The Fed may stop shrinking its balance sheet next year

The Federal Reserve is releasing more signals about future quantitative tightening (QT) removal, with the latest signal coming from the Federal Reserve Bank of New York, which manages the Fed's open market operations.

In the annual report of open market operations released on Wednesday, April 17th, Eastern Time, the New York Fed projected that the Fed's balance sheet reduction (QT) action will end in 2025, next year. The report presented two hypothetical scenarios regarding QT, estimating that it may end in early or mid-next year, after which, for the following year, bank reserves deposited with the Fed are expected to decrease to $2.5 trillion or $3.0 trillion.

The report predicts that in the scenario of higher reserve levels, the Fed's balance sheet size will shrink to around $6.5 trillion, while in the lower reserve scenario, the balance sheet will decrease to $6 trillion.

Additionally, the New York Fed forecasts that due to the increase in the Fed's interest-bearing liabilities cost, the Fed's bond portfolio net income may still be negative this year, and it is expected to return to positive in the following years. Wall Street News previously mentioned that due to the "side effects" of rate hikes, the Fed's operating loss reached $114.3 billion last year, setting a record for the highest annual loss. This loss is unrealized and does not affect the Fed's operations, but it will exacerbate the already large U.S. government fiscal deficit. The timing of returning to profitability depends on when the Fed will cut rates this year and beyond.

Minutes suggest the Fed is preparing to slow down balance sheet reduction soon, Wall Street expects halving of monthly reduction limit for U.S. Treasuries

The Fed started reducing its balance sheet in June 2022, currently maintaining a pace of up to $95 billion per month in U.S. Treasuries and Mortgage-Backed Securities (MBS). Last month's Fed meeting did not make any changes to the reduction action, but the meeting minutes released earlier this month showed that at the previous month's meeting, Fed officials discussed considerations for slowing down the reduction speed, with most leaning towards starting to slow down soon. The minutes stated,

"Participants generally viewed the reduction of the balance sheet as proceeding smoothly, but, in light of the experience of ending the reduction from 2017 to 2019, participants generally believed that a cautious approach to further reduction was appropriate. Therefore, the vast majority of participants believed that it would be prudent to start slowing the pace of balance sheet reduction fairly soon."

The minutes revealed that most Fed officials at the meeting last month agreed to reduce the overall monthly bond reduction size by about half and generally favored slowing down the reduction speed by maintaining the existing limit for MBS and adjusting the redemption limit for U.S. Treasuries. This means that the future slowdown in balance sheet reduction will mainly be achieved by reducing the pace of U.S. Treasury reduction, leading to a decrease in the size of maturing U.S. bonds each month.

Currently, Wall Street strategists expect the Fed to reduce the monthly limit for U.S. Treasury reduction from $60 billion to $30 billion, while keeping the MBS reduction limit unchanged The minutes of last month's meeting stated that most Federal Reserve officials pointed out that although the Fed's balance sheet has shrunk significantly, the reserve balance remains at a relatively high level, as the decrease in the use of overnight reverse repurchase agreements (ON RRP) has shifted the Fed's liabilities to reserves. As the future decline in the adoption rate of ON RRP becomes more limited, further balance sheet reduction may more directly translate into a decrease in reserve balances, which could decline rapidly. Given the uncertainty about what level of reserves is consistent with the ample reserves regime, it is advisable to slow down the balance sheet reduction sooner rather than later to facilitate a smooth transition of reserve balances from ample to sufficient.

Currently, the Fed's bank reserves are around $3.6 trillion. Fed Chair Powell stated in a press conference after last month's monetary policy meeting that the adequate reserve level is slightly less than the current level.

A Goldman Sachs report from November last year pointed out that when bank reserves transition from ample to sufficient, i.e., when changes in reserve supply have a real but moderate impact on short-term interest rates, the Fed may stop reducing its balance sheet. At that time, Goldman Sachs estimated through modeling that short-term interest rates will become more sensitive to reserve changes around the third quarter of this year, and it is expected that the Fed will begin to slow down the balance sheet reduction at that time, halving the monthly reduction caps for treasuries and MBS in the fourth quarter, with the balance sheet reduction ending in the first quarter of next year.

Goldman Sachs also noted that a key risk is that the increase in U.S. debt issuance this year could cause problems in the U.S. Treasury market. To avoid market volatility, the Fed may consider stopping the balance sheet reduction early