Liquidity
November 3, 2025
The U.S. banking system is showing early signs of liquidity stress as bank reserves fall and short-term borrowing costs rise above the Fed’s interest on reserves. This has prompted the Federal Reserve to signal an imminent end to quantitative tightening, and potentially the start of a new round of balance sheet expansion. While the immediate goal would be to stabilize liquidity, such moves could also lower government borrowing costs, raising questions about the Fed’s independence and long-term inflation risks.
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In recent weeks, concerns about liquidity conditions in the U.S. banking system have grown more pronounced. Analysts and market participants are paying particular attention to regional banks, which appear to be facing tighter funding environments. These developments are closely tied to the Federal Reserve’s ongoing process of balance-sheet reduction, commonly referred to as quantitative tightening (QT).
The Motivation Behind the Fed’s Balance Sheet Reduction
The Federal Reserve began quantitative tightening as part of its broader strategy to combat persistently high inflation and normalize monetary policy after years of extraordinary stimulus. During the pandemic, the Fed’s large-scale asset purchases, known as quantitative easing (QE), expanded its balance sheet to nearly $9 trillion, providing abundant liquidity that supported markets and the economic recovery. However, as inflation surged to multi-decade highs in 2022, maintaining such liquidity levels risked keeping financial conditions overly loose.
Quantitative tightening, therefore, serves as a complement to interest rate hikes, withdrawing excess reserves from the banking system and reducing the Fed’s footprint in bond markets. The goal is to tighten financial conditions gradually, temper credit growth, and bring inflation closer to the Fed’s long-term 2% target without destabilizing the banking sector.
Understanding Quantitative Tightening
Since mid-2022, the Federal Reserve has been engaged in quantitative tightening (QT), a deliberate effort to shrink its balance sheet after years of large-scale asset purchases. The Fed holds a vast portfolio of U.S. Treasuries and agency mortgage-backed securities (MBS) accumulated through QE. Under QT, it allows these securities to mature without reinvestment, a process known as passive runoff.
To maintain predictability, the Fed set monthly runoff caps of $60 billion for Treasuries and $35 billion for MBS. This steady reduction has lowered total assets from about $9 trillion in early 2022 to roughly $6.5 trillion, a contraction of around $2.5 trillion.
Because a central bank’s assets and liabilities must balance, asset reduction also shrinks liabilities. For the Fed, these include bank reserves, reverse repurchase agreements, and currency in circulation. Of these, bank reserves are most crucial, as they form the backbone of liquidity in the financial system. As QT has progressed, reserves have fallen from around $4 trillion to $3 trillion, tightening available liquidity.
Ultimately, QT drains cash from the system just as QE once supplied it. The pace of this withdrawal determines how smoothly markets adjust: too slow and inflation risks linger, too fast and funding pressures emerge as reserves become scarce.
Historical Context: Lessons from Previous Quantitative Tightening Cycles
The current QT cycle, launched in June 2022, is the largest in the Federal Reserve’s history. Through passive runoff of U.S. Treasuries and agency mortgage-backed securities (MBS), the Fed has allowed assets to mature without reinvestment, capped at $60 billion and $35 billion per month, respectively. Since then, its balance sheet has shrunk by about $2.4 trillion, from nearly $9 trillion to $6.6 trillion. Starting from an unprecedented scale, this cycle has been closely managed to avoid market stress, and with reserves nearing the “ample” threshold, officials are signaling that QT may soon end.
The previous QT round, conducted between 2017 and 2019, was smaller and slower. Monthly runoff caps peaked at $30 billion for Treasuries and $20 billion for MBS, trimming the balance sheet by roughly $700 billion before ending abruptly amid a repo market liquidity squeeze. That episode forced the Fed to inject funds and reverse course with renewed asset purchases.
Before the 2008 financial crisis, the Fed had never implemented QT. Policy tightening relied solely on interest rate increases, with the balance sheet remaining stable. The introduction of quantitative easing (QE) after 2008 transformed that framework, making QT a permanent, though delicate, tool in the Fed’s policy arsenal.
Are Bank Reserves Still Adequate?
At first glance, $3 trillion in reserves may seem more than sufficient. However, liquidity is a relative concept; it depends as much on demand as on supply. Banks require reserves to meet payments, regulatory obligations, and daily operational needs. When the demand for reserves exceeds the available supply, the financial system begins to feel liquidity pressure.
To gauge these pressures, markets look to indicators such as the Secured Overnight Financing Rate (SOFR), which reflects the cost of borrowing reserves overnight. This rate can be compared with the interest on reserves (IOR) that the Fed pays banks for holding their balances. Under normal, abundant-liquidity conditions, SOFR tends to stay slightly below the IOR. When liquidity becomes scarce, SOFR rises above the IOR, signaling tighter conditions and higher demand for reserves.
Recent data show that SOFR has indeed moved above the Fed’s IOR, reaching one of the widest spreads observed since QT began. While this does not yet point to a systemic banking crisis, it does represent an early warning sign of liquidity stress within the U.S. financial system.
The Fed’s Possible Response: Ending QT and Restoring Liquidity
In light of these developments, Fed Chair Jerome Powell has suggested that the current phase of quantitative tightening may be approaching its end. Halting QT would stop the continued drain of reserves from the banking system. If liquidity conditions worsen, the Fed could even reverse course and expand its balance sheet again through a new round of quantitative easing (QE) to restore liquidity.
The main goal of such a move would be to stabilize short-term funding markets, although it could also have broader side effects. By purchasing U.S. Treasury securities in the open market, the Fed would indirectly reduce the government’s borrowing costs. Economists sometimes refer to this as “fiscal QE,” when monetary policy actions also support fiscal objectives, intentionally or not.
Fiscal Implications and the Question of Central Bank Independence
This overlap between monetary and fiscal policy raises important long-term concerns. If the Fed begins purchasing Treasury securities mainly to ease the government’s financing burden, it risks blurring the line between independent monetary policy and fiscal support. Over time, this dynamic could encourage political leaders to rely on central bank interventions rather than taking difficult steps to reduce deficits or spending.
The backdrop makes this risk more tangible: U.S. federal interest expenses have more than doubled since before the pandemic, driven by both higher debt levels and rising interest rates. With large fiscal deficits persisting, the temptation to lower borrowing costs through indirect monetary accommodation is real, though controversial.
4 Key Takeaways: The Broader Implications If QT Is Approaching Its End
1. Liquidity pressures are emerging: SOFR has risen above IOR, indicating that the demand for reserves is outpacing supply.
2. QT may be nearing its end: The Fed could pause further balance-sheet reductions to prevent additional tightening.
3. Renewed QE remains possible: If liquidity strains worsen, the Fed might expand its balance sheet again, indirectly easing fiscal pressure.
4. Risks to independence: Using monetary policy for fiscal ends could erode the Fed’s credibility, heighten political influence, and eventually fuel inflation.
The Road Ahead for U.S. Liquidity and Fed Policy
The U.S. banking system is showing early signs of liquidity strain, leading the Federal Reserve to consider whether it should end its quantitative tightening cycle and possibly prepare for a renewed phase of balance-sheet expansion. While such action could calm short-term funding markets and lower rates, it would also raise deeper questions about the Fed’s independence and the long-term inflationary consequences of intertwining monetary and fiscal priorities.
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