Former Fed leaders: Wall Street closely watches the Fed's description of QT next week, which is more important than rate cuts!

Former New York Fed President Bill Dudley recently wrote that since interest rate cuts are temporarily off the table, the Fed will focus on a different issue at next week's policy meeting: when and how to slow down quantitative tightening, with the ultimate plan to be in place by mid-year. Dudley emphasized that reducing the balance sheet is aimed at rebuilding easing capacity, and the goal of slowing down quantitative tightening is more important than speed, but this is not enough to affect long-term interest rates or disrupt the market.

The article states that the Fed's securities holdings affect the amount of cash available in the economy. The Fed's purchase behavior injects funds into banks, which then hold these funds in the form of reserves. When reserves are sufficient, money market rates are stable, supported by the interest rate paid by the Fed on reserves. When reserves become excessively scarce, banks scramble for cash, causing money market rates to rise and become unstable.

However, Dudley pointed out that the problem is that no one knows exactly to what extent reserves are scarce. He likened finding this level to landing a plane with an imprecise altimeter. Therefore, the Fed needs to slow down its descent speed when approaching the runway and be extra careful near the touchdown point.

He believes that the Fed still has ample room for maneuver. Currently, reserves are around $3.6 trillion, much higher than the less than $1.5 trillion in September 2019. However, since the end of 2022, these reserves have received nearly $2 trillion in support from the Fed's reverse repo program. With only $445 billion left in the reverse repo program, this support will end soon, and the reduction in the Fed's securities holdings will more directly affect reserves.

Therefore, the question of when to slow down the pace of quantitative tightening has become more urgent. So far, the Fed has reduced its securities holdings from around $8.5 trillion in April 2022 to about $7 trillion today. Its Treasury portfolio is decreasing at a rate of $600 billion per month. Mortgage-backed securities are being reduced more slowly, at less than $200 billion per month: high interest rates mean people are not prepaying, resulting in a reduction rate well below the $350 billion per month limit.

So what's next? Dudley expects the Fed to reduce the pace of Treasury reduction, possibly to $300 billion per month. On the one hand, this is already the fastest reduction rate for this type of security. Additionally, the Fed ultimately hopes to return to holding the entire Treasury portfolio, which would allow the Fed to avoid being seen as favoring the housing sector in credit allocation.

Dudley stated that the second issue is which Treasuries to hold. He said it makes sense to hold more short-term notes, as their yields closely track the interest rate paid by the Fed on bank deposits, reducing the risk of the Fed's interest expenses exceeding its income. For example, last year, the Fed's income from long-term Treasuries and mortgage-backed securities was far less than the sharp increase in interest expenses on reserves, resulting in a $110 billion loss for the Fed, which could lead to further losses this year. In addition, holding short-term assets will increase the Federal Reserve's ability to conduct quantitative easing by reinvesting maturing Treasury bonds into long-term assets instead of expanding its holdings. Dudley believes that this is an attractive option for Fed officials concerned about the Fed's market share in the financial markets.

Although there is much attention on the Fed's balance sheet decisions, Dudley stated that the impact on long-term interest rates should be minimal. Firstly, analysis shows that announcements of quantitative tightening typically result in interest rate changes of no more than 8 basis points, much lower than announcements of quantitative easing. This is logical due to the expected asymmetry. Easing is needed to address significant market or economic shocks, so easing is usually a surprise. However, once easing is in place, tightening is sure to follow, leaving only questions of timing, magnitude, and duration.

Secondly, what truly matters is the endpoint of tightening, which is meeting bank demand, avoiding market disruptions, and ensuring that the federal funds rate remains the primary driver of monetary policy at the required reserve level. The wealth created by the Fed's previous asset purchases has led banks to rely more on reserves as a source of liquidity. Dudley expects the Fed's tightening plan to target reserves at around $3 trillion, double the level in September 2019.

Lastly, the decision for quantitative tightening is not related to the timing and magnitude of reducing the Fed's short-term interest rate target. The Fed is reducing its balance sheet not to tighten monetary policy, but to rebuild its ability for future quantitative easing. These two will only be related when short-term rates approach 0% again or in the event of an emergency in the Treasury market.