Fed to end balance sheet runoff December 1 amid rising funding costs

The Federal Reserve building in Washington, D.C.

The Federal Reserve on Wednesday said it will stop shrinking its Treasury holdings beginning Dec. 1, ending a three-year long effort after stress signals in money markets intensified in recent days.

The central bank said it will stop unwinding Treasury holdings, currently at a pace of $5 billion a month, but will continue the runoff of its portfolio of mortgage-backed securities by about $35 billion a month. It will reinvest the proceeds in Treasury bills, in line with its goal to return to a portfolio consisting primarily of Treasuries, Chair Jerome Powell said at a press conference after the policy decision.

Wednesday’s announcement was a swift reversal for the Fed, which until recently indicated that a decision on the end of the runoff — known as quantitative tightening — was months away.

“Some things have been happening for some time now, showing a gradual tightening in money market conditions, really, in the last call it three weeks or so, you’ve seen more significant tightening,” Powell said. “There’s not a lot of benefit to be holding on to get the last few dollars.”

The move came as funding costs have been rising while liquidity is drying up, leading a number of Wall Street banks to warn that the Fed should abandon the process if it wanted to avoid the kind of distortions that rocked markets in September 2019.

Since the central bank started reducing its $6.6 trillion portfolio in June 2022, more than $2 trillion in funds have left the financial system. This has nearly emptied its main liquidity barometer — the reverse repurchase facility — just as a deluge of short-term debt issuance is luring more cash away.

In turn, several short-term interest rates used by banks to borrow and lend to each other have been rising. Even the Fed’s benchmark rate — which policymakers lowered by a quarter percentage point on Wednesday for the second time this year — has been moving higher within its range.

“The Fed is simply responding to the increase in funding pressures they’ve seen in recent weeks,” Matthew Luzzetti, chief US economist at Deutsche Bank, told Bloomberg Television “We’ve always known that the Fed was going to be very cautious in their balance sheet decisions this time around, wanting to avoid what happened in September 2019.”