The Fed stops shrinking its balance sheet

At its October meeting the Federal Open Market Committee cut interest rates by 25 basis points, as expected, taking the federal funds target to 3.75–4.00 per cent. The bigger news came in the statement. The Fed said quantitative tightening (QT) will end on 1 December.

The decision was not unanimous. Stephen Miran, the governor appointed in September, voted for a larger cut, while Jeffrey Schmid of the Kansas City Fed voted against any cut at all. Jerome Powell then told reporters that another cut in December was far from certain, which sent short-dated Treasury yields higher. The meeting made clear that the committee is divided on rates. On the balance sheet, it was not.

Money markets win the argument

Ending the runoff amounts to the Fed giving way to the funding markets. SOFR has been trading above IORB, and repo spreads have widened under the weight of heavy Treasury bill issuance, which means the Fed's reserve cushion was used up. Its staff concluded that continuing to roll off $25 billion in Treasuries and mortgage-backed securities risked a serious liquidity seizure in money markets.

The signals had been building for weeks. After the debt ceiling was raised in July, the Treasury rebuilt its cash account at the Fed by selling bills, and the money-market funds that had once parked hundreds of billions at the Fed's reverse repo facility moved that cash into bills instead. Once the facility was close to empty, each further drain came out of bank reserves. Banks began to hoard reserves rather than lend them, and overnight rates rose above the rate the Fed pays on reserves, a reversal of the usual relationship.

What changes on 1 December

From December the Fed will keep the size of its Treasury holdings steady by reinvesting all maturing securities. It will also take the principal repaid on its mortgage-backed securities and reinvest it in Treasury bills. That second change matters for the composition of the portfolio. Over time the Fed will hold fewer mortgage securities and more short-term government debt, which is closer to the bill-heavy balance sheet it ran before 2008 and gives it more flexibility to adjust.

The bill purchases also support the part of the Treasury market under most strain. Heavy bill issuance was one cause of the pressure in funding markets, and a steady buyer at the Fed helps absorb it, though the amounts involved are modest relative to total issuance.

The 2019 lesson

The Fed has good reason to act early. In its first round of balance-sheet reduction, it stopped shrinking in the summer of 2019, judging reserves to be ample. Weeks later, in September, repo rates spiked far above the Fed's target range as a tax deadline and a large Treasury settlement drained reserves on the same day. The Fed had to lend in the repo market and then began buying Treasury bills to rebuild reserves. Officials took from that episode the lesson that the point at which reserves become scarce can only be found by reaching it. This time they have chosen to stop before finding out.

Where the shrinking stops

The balance sheet will stop shrinking at roughly $6.5 trillion. That confirms the banking system now needs far more reserves than it did before 2008.

The scale of the change is striking. Before the financial crisis the Fed's balance sheet was well under $1 trillion and banks held only a few tens of billions of dollars of reserves, managing their daily needs by borrowing from each other. At its peak in 2022 the balance sheet was close to $9 trillion. Liquidity rules introduced after 2008 require banks to hold large buffers of high-quality liquid assets, and reserves are the most liquid of all, so demand for them has risen permanently. The Fed formally adopted a system of ample reserves in 2019, and it has now found roughly where ample ends.

The case for a smaller Fed

The strongest argument against the decision is that a large balance sheet has costs of its own. The Fed pays interest on the reserves that fund its holdings, and with rates well above the yield on much of its portfolio, it has been running operating losses since 2022, recorded as a deferred asset running into the hundreds of billions of dollars. Critics also argue that a big central-bank footprint distorts market prices, props up asset values and blurs the line between monetary and fiscal policy. Some of those critics are candidates to succeed Mr Powell next year.

Those arguments have force, but they are arguments for different regulation of banks' liquidity needs or for a different operating system, not for pressing on with runoff while money markets are showing strain. The Fed can revisit the size of its balance sheet later through changes to its lending facilities or to liquidity rules. It cannot easily undo a funding crisis once one starts.

Winners and losers

Money-market funds, dealers and hedge funds that finance positions overnight gain most, since lower pressure in repo reduces their funding costs. The Treasury gains a reliable buyer of bills. Savers who had enjoyed elevated overnight rates will see some of that premium disappear, and advocates of a leaner central bank lose the argument for now.

The indicators to watch are the spread between SOFR and IORB after the month-end, use of the Fed's standing repo facility, and whether the Fed signals purchases of bills to grow reserves in line with the economy next year. From 1 December the Fed's balance sheet will stop shrinking, probably for good. The central bank has decided that keeping the financial plumbing working matters more than getting its balance sheet back to anything like its old size. The next step, likely within months, will be small purchases of bills to let reserves grow with the economy, and funding pressures should ease well before the year ends.