Fed halts QT amid money-market funding strains

As widely expected, the Federal Reserve cut its key rate amid signs of a weakening labor market. But the central bank also said it would halt its quantitative tightening (QT) program — a reaction to concerning trends in the money markets.

QT works by allowing maturing Treasuries and mortgage-backed securities to roll off the Fed’s balance sheet without reinvestment, thereby draining liquidity from the banking system. (That's the opposite of quantitative easing, which injects liquidity and saw extraordinary use to support the economy during the pandemic.)

Three years of QT will end in December, meaning the Fed will start rolling over maturing Treasuries again. We've charted the Secured Overnight Financing Rate, or SOFR, to show the conditions that led to this move.

SOFR reflects the cost of borrowing cash overnight by institutions using Treasuries as collateral. Over the past few weeks, SOFR has persistently spiked higher than another key metric: interest on reserve balance (IORB), which serves as an upper limit for the short-term rate. When SOFR trades at or above IORB, it implies liquidity has tightened: cash scarcity is pushing up market rates. Expressed another way, banks and dealers are willing to pay more for overnight cash than they could earn risk-free at the Fed.

Our subsequent charts explore how the Fed had been unwinding the Covid-19 stimulus through aggressive rate hikes and balance-sheet reduction (often to the displeasure of President Trump). As QT drained liquidity, use of the Fed’s reverse repo (RRP) facility, a key measure of excess liquidity in the financial system, has fallen sharply. That's another indicator signalling tighter money-market conditions.

This latest policy shift is a further pivot away from the Fed's recent tightening cycle. Chair Jerome Powell has indicated that the financial system has moved from an "abundant" to an "ample" reserve level; however, he also pushed back firmly against expectations for another rate cut in December - even though markets had priced in a 90% probability of that occurring.

Our last chart uses the CME's FedWatch tool to chart those perceptions. (The sharp orange spike at bottom right indicates the suddenly realistic possibility of no change to the current key rate.)

*Former New York Fed Governor Bill Dudley recently described "ample reserves" as "banks having enough cash to meet the market’s needs most of the time," with the Fed available to lend more cash against high-quality securities in certain circumstances.

As the US government shutdown persists, click here for alternative indicators that can be used to assess American economic conditions.

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