Keeping an Eye on Liquidity as Risks Converge

The Fed’s close monitoring and well-signaled tapering of QT should prevent disruptions to the short-term funding markets—despite converging risks.

Declining cash reserves across the US financial system have some market observers predicting a liquidity crunch in the funding markets. We disagree. To understand why, it helps to understand how we got here.

The Federal Reserve’s Balancing Act

In 2020, in response to the COVID-19 crisis, the Federal Reserve ensured liquidity in the economy by buying massive amounts of Treasuries and mortgage-backed securities. This quantitative easing (QE), along with other government stimulus measures, ballooned the Fed's balance sheet, flooded the financial system with cash and greased the economic skids.

But QE eventually resulted in excess liquidity in the short-term funding markets—that is, too much cash and too few places to invest it. Since 2022, the Fed has been draining that excess liquidity through quantitative tightening (QT). To shrink its balance sheet, the Fed has stepped back from its role as a major buyer of debt securities and has instead allowed debt on its balance sheet to mature without reinvesting the proceeds.

That leads us to where we are now, with QT on the path to a supply and demand imbalance between cash and securities. For some market observers, this evokes memories of September 2019, when the Fed fumbled QT, bringing short-term funding markets to a standstill.

In 2019, the Fed, having miscalculated the amount of bank reserves needed to keep the system liquid, kept QT going for too long, even as Treasury issuance surged and money market funds saw dramatic outflows. Simply put, there wasn’t enough cash available to meet the supply of securities. Funding rates spiked to 10%, and the Fed had to halt QT abruptly and provide an emergency lending facility to restore liquidity.