As debt ceiling looms, the Fed considers tweaking its portfolio runoff

For the past three years, the Fed has been shrinking the portfolio of Treasurys and mortgage-backed securities that it accumulated during previous stimulus campaigns, including one to stabilize dysfunctional markets when the Covid-19 pandemic upended commerce in 2020.

Now, it could opt to pause that runoff, or slow it down.

Here’s a look at what’s happening:

Why is the Fed considering a change now?

The Fed is trying to avoid a rerun of a situation that occurred in 2019 when it was also shrinking the asset portfolio, sometimes called its balance sheet. Back then, the balance-sheet runoff prompted strains in overnight funding markets that forced the Fed to make a U-turn and expand its holdings.

The potential for a market hiccup will rise in the coming months because of the interplay between the Fed’s balance-sheet runoff and the need by Congress and the White House to raise the federal debt ceiling.

How does the Fed shrink its balance sheet?

The Fed acquired Treasurys and mortgage-backed securities to provide extra stimulus to the economy by driving down longer-term yields in 2020. When the Fed buys a bond from a bank or a bank’s customer, it pays for it through the electronic equivalent of printing money: crediting the bank’s account at the Fed. As its bondholdings grew, so did this electronic cash, called reserves. A bank uses reserves to manage transactions between itself, its customers, other banks and the central bank.

When it reverses this process, the Fed doesn’t sell any of the Treasurys or mortgage-backed securities outright. Rather, as of right now, the Fed allows as much as $25 billion in Treasurys and $35 billion in mortgage bonds to mature every month without reinvesting the proceeds into new securities. When it shrinks those holdings, it also drains reserves.

Why is the debt limit factoring into recent deliberations?

The Fed doesn’t know how many reserves the banking system requires. Allowing too many reserves to drain could lead to turmoil in overnight lending markets. The central bank is monitoring a range of indicators to see when it should stop the process, but the debt limit could interfere with that process because the Fed is also the government’s banker.

When the Treasury Department takes steps to conserve cash to avoid breaching the debt limit, it draws down its general account held at the Fed. The drawdown of that account produces a nearly one-for-one offset with reserve levels, meaning that for each dollar that goes out of the Treasury’s general account, reserves rise by one dollar.

But once the debt limit gets extended—forecasters estimate that will need to happen by August to avoid missing payments—that process will also go into reverse. The Treasury will begin to rebuild its cash balance, and reserves will exit from the banking system rapidly.

At their most recent meeting in January, Fed officials discussed the risk that this could drain too many reserves from the system too quickly. Minutes from that meeting indicated officials discussed slowing down or pausing the balance-sheet runoff for a few months so that the debt limit doesn’t interfere with the Fed’s ability to fine-tune its balance sheet.

What would a pause in balance-sheet runoff accomplish?

Pausing the runoff would be a “tactical decision" that “doesn’t change the end goal" of reducing reserves from the balance sheet, said Roberto Perli, the New York Fed executive charged with overseeing the balance sheet, in remarks this month.

A pause would offer officials an easy way to avoid inadvertently ending up in a situation where they drain too many reserves from the banking system too quickly, said Blake Gwinn, an interest-rate strategist at RBC Capital Markets.

“They have this whole dashboard that they’re looking at to tell them what the right level of reserves is, and the debt limit is going to distort those signals," Gwinn said. Pausing the balance-sheet runoff makes sense “if you don’t trust your instruments—your altimeter or whatever else in your plane," Gwinn added.

Would the Fed resume the shrinking of its holdings after any pause?

As a base case, yes. Fed officials could pause the runoff until several months after the debt limit has been raised and the Treasury has rebuilt its cash balance. At that point, the Fed could continue to resume shrinking reserves on its own terms.

“All they have to do is come out with a statement that says, ‘Out of an abundance of caution, we don’t trust the signals we’re getting out of the market around the debt limit. And so we’d rather just pause to be careful and pick it back up when it’s done,’ " Gwinn said.

A “pause" in balance-sheet runoff could turn into a “stop" if the economy deteriorates in a way that would prompt officials to choose to end this form of policy tightening, Gwinn said.

Write to Nick Timiraos at Nick.Timiraos@wsj.com