The Federal Reserve is too cautious on quantitative tightening

livemint.com:

Inflation remains stubbornly high. That’s why the Federal Reserve, as a part of its monetary tightening, has been reducing the size of its balance sheet, which still has more than $7 trillion in assets left over from its last round of quantitative easing. So why has the Fed now decided to slow the pace of quantitative tightening by $35 billion a month when inflation is still too high? The Federal Open Market Committee’s decision to slow QT comes from a desire to be sure that banks have “ample" reserve balances (deposits held by banks at the Fed) to meet daily cash needs.

Every dollar of these deposits at the Fed must be backed by Fed assets. If the size of the Fed’s balance sheet is brought down too much and too quickly, that creates a risk of cash hoarding by banks—which could cause overnight interest rates to soar, wreaking havoc on wholesale funding markets. This happened in September 2019, during a previous round of QT.

This time around, the Fed is dropping the size of its balance sheet more cautiously. This isn’t a bad idea, but the Fed doesn’t need to be so tentative. There are clear warning signals the Fed could use to monitor the risk of a liquidity crunch before it happens.

Each business day, on average, banks use a payment system called Fedwire to transfer more than $4 trillion from their Fed deposit accounts to one another. Keeping these payments flowing smoothly each day is crucial to the effectiveness of the financial system, since they cover payrolls, vendor payments, trade settlements and many other applications. The largest banks send far more cash out of their Fed accounts each day than their opening balances, which is why they rely heavily on incoming payments from other banks in the middle of each day.