Canadian Imperial Bank of Commerce (CIBC) suggests that fixed income markets are overestimating the potential impact of changes to the Federal Reserve's balance sheet policy, which are likely to be slow and limited. According to CIBC strategists, including Michael Cloherty, the Fed is unlikely to begin shrinking its $6.7 trillion balance sheet before next year. Even then, to avoid unsettling markets, the central bank will not sell assets such as mortgage-backed securities. The Fed is also expected to roll over approximately one-third of its U.S. Treasury holdings.
Policymakers have been discussing ways to reduce one of the main drivers of balance sheet growth: the banking sector's demand for cash held at the central bank. Last week, Dallas Fed President Lorie Logan expressed support for adjusting liquidity rules to lower banks' need for reserves, echoing similar calls from Fed Governor Michelle Bowman and Vice Chair for Supervision Michael Barr.
CIBC strategists noted that a recent Dallas Fed paper on how the central bank could shrink its balance sheet underestimated the costs and risks of rapid reduction. They added that there are potential issues that are "not immediately obvious." For instance, proposals such as lowering bank reserve requirements or implementing tiered interest rates on reserves would increase the importance of money market funds in monetary policy transmission. These funds have been a key tool for the Fed to implement policy via the overnight reverse repo facility. This shift could transfer some control over monetary policy from the Fed to the Securities and Exchange Commission, which regulates mutual funds, potentially limiting banking regulators' influence during crises. The strategists wrote, "During periods of extreme stress, strong regulatory control over entities relied upon for policy transmission can be useful."
CIBC believes the Fed is unlikely to adjust the interest rate on bank reserves or the offering rate on reverse repo agreements, meaning the forward spread between the Secured Overnight Financing Rate and the interest on excess reserves is "somewhat too wide," leading to mispricing in short-term rate expectations.
The bank also highlighted a timing mismatch: regulatory changes aimed at reducing reserve demand would take effect long before the Fed adjusts the asset side of its balance sheet, leaving policymakers uncertain about the new framework's effects for an extended period.
While the Dallas Fed paper argued that reducing demand for reserves by lowering their rate could encourage more active interbank lending, thereby raising rates and revitalizing the dormant interbank market, CIBC countered that a steep money market demand curve reflects the loss of banking safety nets. Without such backstops, supply-demand mismatches in repo markets could "drive prices wildly higher." They noted, "A reserve shortage does not bring substantial benefits from creating an active market. Since triggering a sharp rate spike requires two conditions—a reserve shortage and a market imbalance—the Fed is unlikely to pinpoint the transition from ample to scarce reserves accurately."
Although some proposals advocate greater use of Fed lending facilities, including the discount window, to reduce banks' reserve needs, CIBC pointed out that stigma associated with such borrowing remains a valid reputational concern for banks. Expanding the range of eligible counterparties could also increase the central bank's political risk, exposing it to criticism for aiding lenders shunned by private investors.
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