WSJ: When will the Fed end QT?

On October 28, according to the WSJ, Fed officials will face a sudden and urgent decision at their meeting this week, unrelated to interest rate cuts, on whether to halt the reduction of the Central Bank's $6.6 trillion asset portfolio in a few days or to wait until the end of the year to make a decision.

Just two weeks ago, the Fed seemed to be proceeding with its year-end decision as planned. Fed Chairman Jerome Powell rarely delivered a speech focusing primarily on the technical aspects of monetary policy, stating that the Fed may face a situation in the “coming months” where it needs to end its three-year asset reduction program.

But analysts say that since then, the pressure in the overnight financing market has been greater than expected and may require an early stop.

The debate on when to halt the balance sheet reduction is distinctly different from the widespread expectation this week of either maintaining stable interest rates or cutting them. Instead, the core of these discussions is how to best ensure that the Fed maintains effective control over short-term interest rates.

The Fed expanded its massive portfolio (sometimes referred to as its balance sheet) during the 2007-2009 financial crisis and again purchased large amounts of government debt and mortgage-backed securities during the pandemic to stabilize the markets and stimulate the economy.

Since the size of the balance sheet reached nearly $9 trillion in 2022, Fed officials have been gradually reducing the size of the balance sheet by allowing securities to mature without replacement. When the Fed buys securities, it creates reserves—that is, electronic cash held by banks at the Central Bank. When the securities mature, this electronic money flows out of the financial system.

Fed officials do not want the balance sheet to become too large, as providing the banking system with trillions of dollars in interest-bearing reserves can bring political costs, such as paying banks large amounts of interest. However, officials also need to control short-term interest rates. If rates rise unexpectedly, their fluctuations could affect mortgage rates, commercial loans, and the flow of credit in the economy.

Officials lack experience with the delicate process of shrinking the balance sheet. Just like a driver looking for an exit ramp on an unfamiliar highway, if the wait time is too long, officials risk missing the exit. This would only recreate the situation the Fed leaders have been trying to avoid: in September 2019, the Fed inadvertently used too much reserve, causing overnight lending rates to spike. Officials hurriedly executed a confusing 180-degree turn, injecting cash back into the financial system.

Over the past three years, most of the funds for the Fed's balance sheet reduction did not come from banks, but from a separate deposit tool that money market funds could use to store cash. The size of this tool has declined from a peak of over $2.2 trillion in 2023 and is now almost vacant. As this buffer disappears, every dollar on the Fed's balance sheet comes directly from bank reserves.

In the days following Powell's speech on October 14, as the government issued new debt and withdrew cash from the banking system, overnight rates strengthened—equivalent to large withdrawals by the government's major clients. These financing pressures have pushed the Fed's benchmark federal funds rate higher within the target range of 4% to 4.25%, indicating that reserves in the banking system have become less freely available.

The pressure briefly eased, but reappeared again last week, coinciding with a period when cash flows related to mortgage loans typically suppress the strengthening of money market interest rates. Banks are increasingly using a loan tool from the Fed designed to act as a safety valve, allowing them to exchange securities for reserves, which again indicates that reserves are becoming less abundant.

When Fed officials began to shrink the balance sheet in 2022, they agreed that they would stop the reduction when reserves were “slightly above” the level needed for the smooth functioning of the market.

Lou Crandall, chief economist at research firm Wrightson ICAP, stated that the Fed's current policy framework is designed to detect recent market signals indicating that the Fed is approaching its potential reserve level reduction target. “The proximity alarm has gone off in the cockpit,” he said.

The Fed has twice slowed the pace of balance sheet reduction, with the most recent instance in April this year, reducing securities by about $20 billion per month.

Blake Gwinn, the head of U.S. interest rate strategy at Royal Bank of Canada Capital Markets, stated that continuing to reduce the balance sheet for several months may indicate that the Central Bank is not concerned about recent fluctuations.

“They can continue to delay, but I personally think it should have stopped six months ago,” Gwen said. “There is almost no benefit to doing so, and at the same time, the risk of increased volatility in the overnight lending market does indeed slightly rise.”

The Fed currently allows a maximum of $35 billion in mortgage-backed securities and $5 billion in U.S. Treasury bonds to be reduced from its portfolio each month. Since officials have indicated that once the reductions are complete, they hope to retain only U.S. Treasury bonds on the balance sheet, they may continue to reduce mortgage-backed securities and invest the proceeds from all maturing bonds into U.S. Treasury bonds.

At least one Fed official has hinted that they may prefer to allow the balance sheet reduction to continue for a longer period. Bank Regulatory Vice Chairman Michelle Bowman ( in a speech in September stated that she prefers to set a smaller balance sheet target in the long term than the scale outlined in the 2022 principles, in order to minimize the Fed's influence in the market and enhance the ability to interpret market pressure signals.

Fed Governor Christopher Waller voted against the decision to slow down the pace of the Fed's reduction of Treasury securities in March. He defended the current operating framework during a moderated discussion this month. He stated, “We are at a point where banks must compete for reserves.”

"The current framework wisely ensures that 'people don’t have to rummage around for spare change in their sofas at the end of the day to top up their reserves. In my opinion, that is foolish behavior,' he said.

After deciding when to stop the reduction of the investment portfolio, officials will face other decisions, including when to allow it to grow again and which assets to purchase. The Fed's assets (mainly U.S. Treasury securities and mortgage-backed bonds) are contrasted with liabilities, which include reserves, U.S. Treasury cash accounts, and physical currency.

Even if the Fed stops reducing assets, any growth in non-reserve liabilities will lead to a corresponding decline in reserves. As a result, officials will ultimately have to decide when to resume purchasing securities to prevent further passive reduction of reserves.