Vincent Reinhart, former Fed staffer and chief U.S. economist at Morgan Stanley, thinks the Fed’s thinking is straight out of Peter Pan:
Reinhart said the Fed’s impossible thing is how they think they can raise interest rates with a big balance sheet without embracing its new tool – overnight reverse repo trades.
The Fed placed a $300 billion cap on volume of reverse repo trades. A reverse repo is when the Fed accepts cash from counterparties such as banks and money-market funds on an overnight basis in return for a security.
But the Fed doesn’t seem to want to want to make the reverse repo facility very large, wary of its market impact.
“If they don’t sell assets or drain them on a temporary basis in large scale, then the volume of reserves in the banking system will undermine the reserves market. They cannot have both small reverse repos and a meaningful effective funds rate,” Reinhart said in a follow-up email.
I’ve lost track of how many trillions are on the Fed’s balance sheet, or how many trillions cycle through the big central bank every year — but at some point, the numbers are just so enormous that it no longer matters. The fact is that there is so much money under the control of so few people that nobody really knows, nobody really can know, what will happen when the Fed starts to unwind that massive balance sheet.