While markets have been focused on the expected trajectory of short-term interest rates through Federal Reserve (Fed) rate cut expectations, the Fed’s balance sheet has recently come into focus as well. In his speech last week, Fed Chair Jerome Powell signaled the central bank may stop shrinking its balance sheet in the coming months to preserve liquidity in overnight funding markets.
The Fed has been reducing its balance sheet by allowing bonds to mature without replacement in an effort to drain excess liquidity from the economy (colloquially called quantitative tightening, or QT). The Fed has shrunk its balance sheet by over $2 trillion, which has come mostly from a corresponding reduction in the Fed’s overnight reverse repo program (O/N RRP). At $4 billion, O/N RRP is at its lowest level since 2021. The Fed has noted that as that facility approaches $0, the Fed will likely need to reassess its ability to drain excess liquidity from the economy without potentially disrupting short-term funding markets. Moreover, as the O/N RRP drops to $0, further balance sheet runoff will have to come directly from the reduction in bank reserves, which recently fell below $3 trillion.
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