Behind the Fed’s move to keep government debt – Bill Dudley

Key topics:.Fed slows Treasury runoff to maintain liquidity amid debt limit uncertainty.Concerns over reserve shortages echo 2019 market turbulence fears.Future shift toward all-Treasury portfolio remains a long-term goal..Sign up for your early morning brew of the BizNews Insider to keep you up to speed with the content that matters. The newsletter will land in your inbox at 5:30am weekdays. Register here..Support South Africa's bastion of independent journalism, offering balanced insights on investments, business, and the political economy, by joining BizNews Premium. Register here..If you prefer WhatsApp for updates, sign up to the BizNews channel here..By Bill Dudley___STEADY_PAYWALL___.The Federal Reserve has raised some questions with its recent decision to slow the pace at which it's shrinking its more-than-$4-trillion pile of Treasury securities. For example: Is it merely preparing for an adjustment to the federal debt limit, or is it trying to avert a crisis in the US government bond market?.With apologies for dampening the drama, I'm going with the mundane explanation..Over the past couple decades, the Fed's holdings of Treasury and mortgage securities have played a crucial role in monetary policy. After the 2008 financial crisis, and during the global pandemic, its asset purchases — known as quantitative easing — pushed down long-term interest rates and increased the reserves that banks held at the Fed. Since March 2022, it has been unwinding that stimulus, allowing its holdings to run off gradually with the aim of reaching the level of reserves banks need to satisfy their liquidity needs, with a buffer above that for safety..Now, though, the impending Congressional fight over raising the federal debt limit is complicating things. When the government hits the limit, it can't borrow to finance deficit spending. To make payments, the Treasury will have to draw down its balance at the Fed, potentially adding hundreds of billions of dollars in reserves to the banking system. Later, when Congress agrees to increase the limit as it always has, the Treasury will replenish its Fed account, depleting reserves at a rapid pace that — if the level drops too low — could force banks to scramble for cash..The Fed doesn't want a repeat of September 2019, when a shortage of reserves caused interest rates to spike. It considers the current supply to be well above "ample," the level required to ensure that short-term fluctuations in reserves don't destabilize rates, but it can't know precisely how much banks will need. Hence, out of an abundance of caution, to ensure that reserves remain plentiful as the Treasury rebuilds its cash balance, it's adjusting the pace of quantitative tightening. Beginning next month, it'll reduce the cap on the monthly runoff of its Treasury securities, to $5 billion from $25 billion. The cap on mortgage securities will remain the same, at $35 billion (though the actual runoff has been slower, at about $15 billion a month)..Read more: 🔒 Fed struggles amid unprecedented uncertainty – Jonathan Levin.Granted, the Fed's move will have a small marginal impact on the US government's borrowing needs. Once the debt limit is raised, the Treasury will have to issue slightly less debt to replace the smaller run-off from the central bank. But it's a pittance in the context of a budget deficit running at roughly $2 trillion annually. It should have no bearing on whether bond investors will freak out about America's fiscal outlook, which I agree is dire. The implications for monetary policy are also negligible..Why, one might ask, didn't the Fed just end the Treasury runoff completely? The $5 billion cap might represent a compromise to gain the broadest possible support (one official, Fed Governor Chris Waller, still dissented). Alternatively, it might signal that the runoff rate could be increased again if Congress raises the debt limit soon. I doubt that will happen: The deliberations will probably be lengthy, and the drain on reserves will be intense when the Treasury replenishes its cash at the Fed..Could a shortage of reserves nonetheless destabilize markets? It's not beyond the realm of possibility, but the risk is less than in 2019, because the Fed has established a standing repo facility where banks can borrow against their Treasury and mortgage-backed securities at the top end of the central bank's target interest-rate range. Banks might balk at tapping the facility, for fear of being perceived as desperate. But if money-market rates spike above what the Fed offers, I'd expect any stigma problem to dissipate. After all, why wouldn't you borrow at the lowest rate that is available?.At some point, when there's still a considerable margin above its estimate of banks' desired reserves, the Fed will likely stop the Treasury runoff altogether. It'll start reinvesting mortgage-security prepayments into Treasuries, maintaining the level of reserves needed to accommodate economic growth. To achieve its goal of a Treasury portfolio that reflects the broader market, it'll have to overweight purchases of short-term T-bills, which are currently underrepresented (at only about $195 billion of the more than $4 trillion total). It'll also move toward an all-Treasury portfolio, but very slowly: It'll want to hold mortgage securities to maturity rather than booking the losses that selling would entail – and many of those securities still have at least 25 years to go..Read also:.🔒 FT: Retail investors defy market turmoil, pouring $67bn into US stocks in 2025🔒 Gamestop joins Bitcoin bandwagon, board approves treasury reserve asset🔒 Cathie Wood doubles down on Tesla, predicts surge to $2,600.© 2025 Bloomberg L.P.

Behind the Fed’s move to keep government debt – Bill Dudley

Key topics:

Related Stories