Earlier this month, the Federal Reserve announced it would slow the pace of its balance sheet contraction to avoid unnecessary market turmoil.
Effective June 1, the limit on non-replaceable Treasury securities will be reduced to $25 billion from the current monthly limit of $60 billion. However, the $35 billion limit on monthly payments on mortgage-backed securities (MBS) will remain unchanged. , and any excess principal payments will be reinvested in Treasury securities.
The pace adjustment for the second round was largely expected, although there was uncertainty as to whether it would be announced at the current Federal Open Market Committee (FOMC) meeting or at the June meeting.
Additionally, many analysts had expected the Treasury spending limit to be lowered to $30 billion, making the decline to $25 billion somewhat surprising.
“Treasury limits will be reduced to $25 billion per month, slightly lower than our expectation of $30 billion per month,” Citi economists said.
“The Fed will stop shrinking its balance sheet if they ease policy in response to the recession. We continue to expect a recession in our base case for this year and therefore expect the Fed to end its balance sheet contraction in September,” they added.
However, if economic activity remains more resilient than expected, Citi forecasts that balance sheet contraction could continue through the end of the second quarter of 2025.
Citi economists attribute this in part to the fact that balance sheet contraction has slowed more than initially expected. However, even under different Treasury General Account (TGA) scenarios and with reverse repo operations potentially falling to zero, they believe bank reserves should remain elevated throughout the year without a significant increase in secured and unsecured overnight rates relative to administered rates.
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Economists said they will monitor volatility and SOFR (secured overnight funding rate) levels, as well as the effective federal funds rate, as early indicators that reserves may be approaching sufficient levels.
In the week ending May 1, the Federal Reserve’s balance sheet shrank by about $40 billion. Treasury assets fell by $21.9 billion and MBS assets fell by $12.7 billion. Discount window lending fell slightly and loans issued under the bank term financing program fell by $1.4 billion.
Meanwhile, a notable change on the liabilities side was a US$17.8 billion decline in foreign official deposits, reversing the previous week’s rise. This indicates that the foreign central bank or institution needed to complete the US dollar transaction between April 24 and May 1. Foreign official reverse repo fell slightly by $8 billion.
The Treasury is also reducing its cash account after significant inflows during tax week, with the TGA balance falling by $38.9 billion to $890 billion. A small reduction in reverse repos increased bank reserves by $45 billion, reaching $3.3 trillion.