The Federal Reserve's program to repair strains in money markets has proceeded with relative steadiness even as geopolitics and broad economic challenges complicate the policy environment. After initiating a multi-month effort to bolster cash in money markets, the central bank is expected to taper the intensity of its renewed Treasury bill purchases as planned after the mid-April tax date, market participants say. At the same time, Fed officials are working to adjust the average maturity of the central bank's sizable bond portfolio so it more closely resembles the maturity profile of the broader Treasury market.
The liquidity operation began in December when the Fed commenced purchases of roughly $40 billion per month in Treasury bills. The program was designed to run at least through the mid-April tax date. The explicit objective was to ensure the banking system had sufficient reserves so the Fed could retain effective control over its short-term interest rate target. Participants also noted a secondary, related goal: nudging the composition of the Fed's holdings toward shorter maturities.
Gennadiy Goldberg, head of U.S. rates strategy at TD Securities, said market participants believe the Fed has "largely accomplished their goals," and that once the tax date passes, purchases will be dialed back to better mirror economic growth. "We expect the Fed to slow the pace of purchases to keep pace with economic growth," Goldberg said. He added that the Fed is likely to reduce T-bill buying to about $20 billion per month and to continue reinvesting proceeds from maturing mortgage bond holdings into bills.
Goldberg framed the adjustment as a way to manage the balance sheet's trajectory: "The adjustment of Fed holdings will keep the balance sheet growing proportionally to the growth rate in the economy, keep (mortgage-backed securities) decreasing as a portion of the balance sheet, and shorten the balance sheet's overall duration." With that gradual change in the average maturity of holdings, market participants have also observed a contraction in the Fed's overall footprint in the Treasury market.
Match game: aligning maturities
Bringing the Fed's holdings into closer alignment with the market's maturity distribution is proving to be a protracted effort, in part because of the central bank's aggressive purchases of longer-dated securities during the COVID-19 crisis. Those purchases were intended to suppress long-term borrowing costs as a form of stimulus. The resulting skew toward longer maturities has complicated efforts to reduce the share of long-term securities on the Fed's balance sheet between 2022 and late last year.
Kansas City Fed leader Jeff Schmid expressed concern about the duration mismatch, saying recently that he worries the Fed's balance sheet has a duration "of about eight-and-a-half, nine years," while the Treasury's portfolio sits at "about five, five-and-a-half years," a gap he said "does create a distortion." Schmid pinpointed one clear practical effect of that distortion: mortgage rates that are likely "75-to-100 basis points lower than they would otherwise be," a phenomenon he tied to the balance-sheet composition.
Derek Tang, an analyst with research firm LHMeyer, estimated that restoring a share of Treasury bills comparable to roughly a third of the portfolio would be a multi-year process. "Given the current outlook for how the Fed is moving into Treasury bills and managing the runoff of longer-term holdings, it will still take 2-3 years to get the bill share back up to close to a third of the portfolio," Tang said. He added that he expects the Fed's approach to remain largely passive, meaning it would not involve active sales of longer-dated Treasuries in order to purchase shorter maturity bills.
Governance, debate and potential shifts
Kevin Warsh, who has been nominated to succeed current Fed Chair Jerome Powell when his term ends in May, has previously criticized how the central bank manages its balance sheet and has said he would prefer a smaller set of holdings. Observers remain uncertain about how Warsh, if confirmed, would achieve such a reduction given how integral the Fed's balance sheet has become to the management of the policy rate. It is also unclear how much appetite exists among current Fed officials for aggressive changes to the balance-sheet regime.
Fed Governor Christopher Waller defended the broader logic of the Fed's approach to reserves management, emphasizing the priority of ensuring banks have the liquidity they need to avoid nightly scramble for funds. "All you're trying to do is provide all the reserves that the banking system needs and wants to make sure there's no financial problems," Waller said. He added bluntly that banks searching "every night ... digging around in the couch cushions, looking for money" would be "massively inefficient, stupid."
Waller and other officials have suggested that regulatory adjustments could reduce banks' demand for cash. Fed Vice Chair for Supervision Michelle Bowman is leading efforts to ease some regulatory requirements that affect bank demand for reserves. Even with regulatory change, Waller warned against reverting to a pre-crisis framework that kept liquidity scarce and required constant Fed fiddling to keep the federal funds rate on target. "Scarcity is not the objective in economics, never has been, never should be," he said, and he argued that principle should guide Fed liquidity management.
That said, several Fed officials have signaled openness to revisiting the detailed mechanics of the current regime, albeit slowly and methodically. Minneapolis Fed President Neel Kashkari described the present system as having evolved into something more complex than originally explained, saying, "this very simple regime that we've created is not nearly as simple as it was originally explained." He suggested it would be appropriate to evaluate whether the current set-up is optimal for the U.S. economy.
Cleveland Fed President Beth Hammack emphasized the deliberate pace of potential reforms. In a recent interview, Hammack said changes at the Fed are implemented "very methodically, very carefully...I expect that if we were going to make a change, there'd be a really rigorous set of discussion and debate around it." Such deliberation implies any substantive shift in balance-sheet strategy would unfold gradually.
Where this matters
The Fed's actions affect multiple corners of financial markets: money-market liquidity determines how smoothly short-term funding and overnight rates operate; the composition and duration of the balance sheet influence the Treasury market and mortgage rates; and regulatory shifts that alter banks' demand for reserves could feed back into how much cash the Fed needs to supply. Market participants expect a measured transition - continued reinvestment into bills, a reduction in the pace of new bill purchases after the mid-April tax date, and a multi-year pathway to rebalancing maturities.
For now, the Fed's management of its balance sheet stands out as a relatively steady policy project amid a more uncertain backdrop for interest rates and economic growth.