The Fed Signals End to Balance Sheet Reduction Amid Market Strains

Policy Shift on the Horizon

After years of steadily shrinking its vast portfolio of government debt and mortgage-backed securities, the Federal Reserve is now signaling that the process may be coming to an end.
Officials are expected to discuss the issue at this week’s Federal Open Market Committee (FOMC) meeting, where Chair Jerome H. Powell could announce a shift away from “quantitative tightening.”

“We’re likely nearing the end of balance sheet runoff,” Mr. Powell said recently, hinting at a potential policy pivot after months of financial market turbulence.

From Quantitative Easing to Tightening

The Fed’s current policy marks the reversal of its massive quantitative easing (QE) campaigns during past crises.
Through QE, the central bank purchased trillions in Treasuries and mortgage bonds to lower borrowing costs and support liquidity.

As those holdings have been gradually reduced — a process known as quantitative tightening (QT) — the total cash circulating through the system has shrunk.
While designed to normalize monetary policy, QT has occasionally strained short-term funding markets.

Warning Signs in Short-Term Funding

This month, the secured overnight financing rate (SOFR) — the benchmark for overnight borrowing — briefly rose above the Fed’s target range, suggesting that liquidity in money markets is thinning.

Several banks turned to the Fed’s standing repo facility, a safety valve created after the 2019 funding crunch, when the central bank’s balance sheet reduction triggered a sudden spike in short-term borrowing costs.

“Alerts are going off on a very regular basis right now,” said Lou Crandall, chief economist at Wrightson ICAP. “We’re getting clear signs that we shouldn’t be complacent.”

A Delicate Balance Between Inflation Control and Market Stability

While inflation has cooled compared with 2022 highs, financial conditions remain tight.
Analysts warn that continuing QT for too long could starve the banking system of reserves, heightening volatility in bond and repo markets.

The Fed must now balance its anti-inflation mandate with the need to maintain market stability, particularly as Treasury issuance remains elevated and liquidity demand surges near quarter-end.

Looking Ahead: A Gradual Policy Pause

Economists expect the Fed to halt balance sheet runoff within months, shifting to a steady-state regime where it reinvests maturing securities rather than allowing them to roll off.

Such a move would mirror the Fed’s 2019 decision to intervene after reserves fell below what the system required to operate smoothly.
The difference now: the balance sheet is still nearly $7.5 trillion, about double its pre-pandemic size.

If the Fed indeed pauses QT, it could mark another major policy recalibration in the post-COVID monetary landscape — signaling that liquidity, not inflation, is once again the central bank’s top concern.