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The Fed and Evolving QT - April 30, 2019

“I Would Be Extremely Nervous”

 The FOMC meeting starts today and rates are once again on everyone’s mind. The president is no exception, tweeting that the economy has the “potential to go... up like a rocket if we did some lowering of rates”. While ex-Fed Kocherlakota may have been supportive of cuts, as we detailed last week, it appears that other Fed heads are coming around. As Nick Timiraos of the Wall Street Journal reported, Fed officials are talking about “the conditions under which they would cut interest rates, including a scenario where inflation drifts lower even if the economic growth doesn’t falter”. Chicago Fed President Charles Evans would be watching for core inflation to stay near 1.5% for “several months” to consider “taking out insurance” in the form of rate cuts. Fed Vice Chairman Richard Clarida appears to be thinking on similar lines, recently referencing the 1990s as an example of when central banks “took out some insurance cuts”. The market-implied odds of a cut have increased slightly since last week but are still in the single digits going into tomorrow.

 “These Numbers, Of Course, Are Only Guesstimates”

 More surprising than the rate commentary is the huge resurgence in talk about QT. Despite the Fed announcing in March that the unwind would end after September, the issue of the appropriate level of reserves remains unresolved. After first assuming that the balance sheet roll-off would be like “watching paint dry”, the Fed reassessed its estimate of “ample” reserves following the market’s sputtering late last year. The St. Louis Fed found “market participants” estimated reserves in “a range of $1 trillion to $1.4 trillion”.

There are some estimates that the number is closer to “$800 billion”, but some St. Louis Fed economists think that the demand for reserves could be “significantly curtailed” through a “standing repo facility”. Initially suggested in a March St Louis Fed paper by David Andolfatto and Jane Ihrig, the idea was to “incentivize banks to reduce their demand for reserves by operating a ... facility that would permit banks to convert Treasuries to reserves on demand at an administered rate”. No more worries about liquidity in times of stress! In a follow-up paper, Andolfatto and Ihrig explain some “additional thoughts” on the usefulness of a repo facility, admitting that the numbers are “guesstimates”. While the coverage of this idea has revolved around “tinkering in markets” and “repackaged... quantitative easing” it is more worrying that the Fed seems to have no idea as to the appropriate level of reserves. The level of “ample reserves”? What is it