Thread by @NickTimiraos

The Fed successfully flooded markets with cash late last year to avoid a spike in overnight lending rates. Now, officials have to decide when and how to wind down the program

A few considerations: wsj.com/articles/with-…

There's a debate over whether or not investors think the Fed's bill-buying binge is akin to 'QE'—either through portfolio balance effects, which many current and former Fed officials think is remote, or through harder-to-quantify means by boosting psyche and animal spirits

Maybe this debate matters because as witnessed with the confusion in December 2018 over the impact of balance sheet runoff ('QT'), what investors think can take on its own self-fulfilling properties. It could potentially complicate ending the latest purchases.

The Fed reduced its balance sheet by nearly $700 billion between October 2017 and July 2019, when the runoff ended. It has since reversed almost half of that runoff, adding more than $300 billion to its balance sheet since September, through repos and Treasury bill buying.

The big question is how many reserves does the system need for the Fed to implement monetary policy smoothly.

It appeared in September that the Fed had drained too many reserves from the system. Officials thought they could let reserve balances fall to $1 trillion or $1.2 trillion, but it turned out that when reserves fell below $1.4 trillion, banks acted as if reserves were scarce.

So again, the key question is how many reserves do officials now think is appropriate to keep at seasonal low points in order to avoid a rerun of the September repo ruckus™. Powell has said at least $1.45 trillion, but it's possible officials will want a bigger balance.

To keep reserves from falling further, the Fed has done two things 1) It has conducted regular overnight and term repo operations 2) To permanently restore reserves (and obviate the need for these repo operations), they are buying T-bills. Currently at a pace of $60 billion/month

In the absence of these two tools, reserves would sit at $1.2 trillion, well below the desired $1.45 trillion

With the bill purchases only, reserves would be at around $1.42 trillion

Reserves are currently at $1.6 trillion thanks to around $180 billion in outstanding repo

(That above chart is courtesy @Fedwatcher.)

Assume that over the next three months, the Fed replaces all of the outstanding repo operations with reserves created from bill purchases, that would get reserves to $1.6 trillion on a permanent basis.

For people who want to know how long the Fed will continue to buy bills, the question really comes down to this: How many reserves does the FOMC think are needed? This destination will inform how long the Fed continues bill purchases beyond the next few months.

If they want reserves during seasonal low points to be a bit higher, then they'd need to buy bills a little longer.

Maybe they decide to simultaneously take steps to increase banks' willingness to substitute reserves for Treasuries, marginally easing demand for reserves.

Questions about the pace and size of bill purchases are the means, but the end is really "how many reserves should the Fed supply" in its new-ish floor system. /end