The Fed is not far from slowing its balance sheet reduction, but finding the optimal reserve balance point will be tested

(1) The Fed is on the verge of a rare soft landing for the economy, but it also faces another worrying challenge, which is to reduce money in the financial system without disrupting the markets. (2) The Fed has withdrawn about $1.4 trillion as it has pulled back about $1.4 trillion as it shrinks its balance sheet to end pandemic-era support measures, and the focus is now shifting to when it should stop shrinking its balance sheet. The fear now is that if the reserves in the banking system break through a certain point of the lowest level, the market will freeze. But no one knows exactly where that level is. (3) Fed Chair Jerome Powell said last week that policymakers were about to make the decision to slow the pace of quantitative tightening to allow reserves to “land smoothly and easily.” Powell said they were watching “a range of different indicators” in the currency market to see when they were approaching that point. (4) Market participants said that despite the daunting task ahead, the Fed’s focus is on reassuring Wall Street. At a time when the Fed is trying to move reserves from “abundant” to “ample” without making them scarce, it’s hard to do that because the lines are blurred. And the market signals that guide this change are noisy and difficult to discern. (5) They said that the indicators that the Fed may focus on include: bank reserves, some key interest rates in the money market, and cash deposited in the Fed’s overnight reverse repo facility. (6) Mark Cabana, head of U.S. rates strategy at Bank of America, said that achieving a soft landing would be “a feat” for the Fed. A soft landing here refers to the Fed maintaining an appropriate level of reserves in the banking system. But he added that he thinks they now have a “good opportunity” because they have taken a more lenient stance. (7) He expects the Fed to announce a slowdown in balance sheet reduction as early as May, halving the cap on its monthly Treasury holdings reduction to $30 billion. John Velis, U.S. macro strategist at Bank of New York Mellon, agrees on the size and timing of the slowdown in balance sheet reduction. (8) It is important for the Fed to shrink its balance sheet at a reasonable pace, as insufficient reserves could cause a sudden spike in interest rates, disrupt the U.S. Treasury market, and make it difficult for companies to raise funds. The situation could be tested in the coming weeks, when events such as quantitative tightening and the April 15 tax deadline will reduce cash in the financial system and demand for cash will rise. However, so far, the market is still functioning normally