The reserve balances of U.S. banks have fallen below $3 trillion, indicating "tight liquidity" in the financial system, and the Federal Reserve needs to stop balance sheet reduction.

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As the Federal Reserve's reserve balances have declined for seven consecutive weeks and fallen below the $3 trillion mark, concerns about tightening liquidity in the market are intensifying.

According to data released by the Fed on Thursday, for the week ending September 24, reserves in the U.S. banking sector decreased by about $21 billion to $2.9997 trillion, falling to the lowest level since January 1 this year after seven straight weeks of decline. This drop in this key indicator directly reflects the ongoing loss of liquidity in the financial system, caused by both the Fed's quantitative tightening and large-scale U.S. Treasury issuance.

Meanwhile, this week, the effective federal funds rate, the Fed’s main policy rate, has edged higher within its target range—an early sign pointing towards tightening financial conditions.

Although Fed Chair Jerome Powell stated last week that reserves are still at "ample" levels, signals from the financial market indicate the critical point may be closer than policymakers expect. This trend is forcing the market to reassess the timeline for the Fed to halt its balance sheet reduction (QT) and to closely monitor any signs of potential funding stress.

Liquidity Drain Under Dual Pressures of QT and Treasury Issuance

The ongoing loss of liquidity in the current financial system mainly stems from the overlap of two major factors.

First, the Fed continues its quantitative tightening process, allowing its bond holdings to mature without reinvestment, which directly drains funds from the financial system. Since QT can intensify liquidity constraints and cause market volatility, the Fed slowed the pace of its balance sheet reduction earlier this year.

Second, after the debt ceiling issue was resolved in July, the U.S. Treasury sharply increased its debt issuance to rebuild its cash balance. This also draws liquidity away from other Fed liabilities (such as bank reserves and the overnight reverse repurchase (RRP) facility).

With funds in the RRP facility nearly depleted, the pressure of tight liquidity is increasingly manifesting itself in commercial banks’ reserve accounts. Data shows that the decline in cash assets held by foreign banks is even faster than that at U.S. domestic banks.

Federal Funds Rate Rises Slightly, Market Signals Tightening

One of the most direct reflections of tightening liquidity is changes in key overnight rates. According to data from the New York Fed released Tuesday, the effective federal funds rate rose one basis point to 4.09% from the previous trading day's 4.08%.

While this rate is still within the Federal Open Market Committee’s (FOMC) target range of 4% to 4.25%, it is noteworthy that over the past two years, this gauge was firmly pinned near the bottom of the range. Its current upward trend is being interpreted by the market as a signal of rising funding costs and tighter financial conditions.

The federal funds market used to be a sensitive indicator of interbank funding conditions. However, after massive monetary stimulus during the financial crisis and the pandemic, U.S. banks became flooded with dollars, leading many to withdraw from this market and instead deposit idle funds directly at the Fed.

According to Wrightson ICAP senior economist Lou Crandall, as surplus funds available to non-U.S. institutions for lending have decreased, the trading volume supporting the federal funds rate has declined.

The Fed at a Crossroads

Faced with increasingly apparent signs of liquidity tightening, the Fed is standing at a difficult crossroads.

Powell said last week that bank reserve balances remain "ample" and expects QT to continue until reserves reach a "sufficient" level. Although he admitted the threshold is getting closer, he did not give a clear stop signal.

Current market dynamics have also sparked debate over the effectiveness of the Fed’s current monetary policy framework. Dallas Fed President Lorie Logan said Thursday that the Fed should consider abandoning the federal funds rate as its benchmark for implementing monetary policy and instead adopt an overnight rate linked to the more active U.S. Treasury collateralized lending market.

Lorie Logan argued that the federal funds rate target is outdated, as its underlying interbank market sees low usage and its link to broader overnight money markets is "fragile" and "could break suddenly."

She proposed that updating the Fed's mechanism for implementing monetary policy should be part of "efficient and effective central banking operations."

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