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Central Bank Watch

FED’S BALANCE SHEET REDUCTION MIGHT SOON END

ADMIN || 8th October 2025

Due to the continued outflow of liquidity from the US financial system, reserves in the U.S. banking system have dropped significantly for the eight consecutive weeks, falling below $3 trillion. Bank reserves are a key factor in the Federal Reserve's decision to continue reducing its balance sheet.

Fed Chair Jerome Powell had said last month bank that reserve balances are still “abundant” and have yet to reach the minimum level needed to cushion against market disruptions, though he acknowledged they’re getting closer. Fed Governor Christopher Waller had earlier estimated that level known as ample at $2.7 trillion.

But if we look at overnight funding markets, where banks and asset managers borrow and lend to each other on a day-to-day basis, they have been volatile since the beginning of September. Ultra-short-term interest rates, which have been steadily rising as the Treasury is rebuilding its cash pile, remain stubbornly elevated even after a benign quarter end.

As a result, the gap between the Secured Overnight Financing Rate and the effective fed funds rate the central bank’s benchmark rate is near its widest level since the end of 2024.

With market metrics showing that funding costs are getting tighter, market observers say that the ample reserve levels are fast approaching.

There is divided opinion inside Fed on how they should operate it’s balance sheet considering the US bank reserves. Fed Vice Chair for Supervision Michelle Bowman said at the end of September the Fed should seek to achieve the smallest balance sheet possible, with reserve balances at a level closer to scarce than ample. That’s in contrast with Powell, Logan and others who have suggested that the runoff should end once reserves are near ample, likely by the end of this year.

In our view, recent funding spreads are a clear indicator of liquidity stress building up in the system. The Tri-Party General Collateral Rate (TGCR) has started settling above the IORB (4.15%) last week though it has come down lower yesterday below IORB. We expect Fed to start discussing ending it’s current QT by Dec policy. Since April 2025, the QT pace has slowed, with monthly caps of $5 billion for Treasuries and $35 billion for MBS.

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