The balance of reserves in the U.S. banking sector has fallen below $3 trillion, indicating "liquidity tightness" in the financial system, and the Federal Reserve needs to stop tapering

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

According to data released by the Federal Reserve on Thursday, as of the week ending September 24, U.S. bank reserves decreased by approximately $21 billion to $2.9997 trillion, marking the lowest level since January 1 of this year after a seventh consecutive week of decline. The decline in this key indicator is a direct reflection of the ongoing loss of liquidity in the financial system due to the Federal Reserve's quantitative tightening and the U.S. Treasury's large-scale bond issuance.

Meanwhile, this week, the effective federal funds rate, which is the Federal Reserve's main policy interest rate, has slightly increased within the target range, signaling an early indication of tightening financial conditions.

Although Federal Reserve Chairman Jerome Powell stated last week that reserves remain at "ample" levels, signs in the financial markets suggest that the critical point may be closer than policymakers expect. This trend is forcing the market to reassess the timeline for the Federal Reserve to halt its balance sheet reduction (QT) and closely monitor any potential signs of funding stress.

Liquidity Loss Under the Pressure of Balance Sheet Reduction and Bond Issuance

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

First, the Federal Reserve continues its quantitative tightening process, allowing its held bonds to mature without reinvestment, which directly withdraws funds from the financial system. Due to concerns that QT may exacerbate liquidity constraints and lead to market turmoil, the Federal Reserve has slowed its pace of balance sheet reduction earlier this year.

Second, after resolving the debt ceiling issue in July, the U.S. Treasury significantly increased debt issuance to rebuild its cash balance. This has also siphoned liquidity from other items on the Federal Reserve's liabilities side (such as bank reserves and the overnight reverse repurchase agreement tool, or RRP).

As funds in the RRP tool have nearly been exhausted, the pressure of liquidity tightening is increasingly reflected in the reserve accounts of commercial banks. Data shows that the rate at which cash assets held by foreign banks are declining even exceeds that of domestic U.S. banks.

Slight Increase in Federal Funds Rate Signals Market Tightening

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

Although this rate remains within the target range of 4% to 4.25% set by the Federal Open Market Committee (FOMC), it is noteworthy that this indicator has been firmly pressed near the lower limit of the range for the past two years. The current upward trend is interpreted by the market as a signal of rising financing costs and tightening financial conditions.

The federal funds market was once a sensitive indicator of interbank financing conditions, but after large-scale monetary stimulus during the financial crisis and the pandemic, the U.S. banking system is flooded with dollars, leading banks to withdraw from this market and instead deposit idle funds directly with the Federal Reserve.

According to Wrightson ICAP senior economist Lou Crandall, the trading volume supporting the federal funds rate has decreased due to a reduction in surplus funds available for borrowing by non-U.S. institutions

The Federal Reserve at a Crossroads

Faced with increasingly evident signs of liquidity tightening, the Federal Reserve is confronted with a difficult choice.

Powell stated last week that bank reserves remain in a "ample" state and expects the balance sheet reduction to continue until reserves fall to "adequate" levels. Although he acknowledged that we are getting closer to this level, he did not provide a clear signal to stop.

Current market dynamics have also sparked discussions about the effectiveness of the Federal Reserve's monetary policy implementation framework. Dallas Fed President Lorie Logan stated on Thursday that the Federal Reserve should consider abandoning the federal funds rate as its benchmark for implementing monetary policy, instead adopting an overnight rate linked to the more active U.S. Treasury secured lending market.

Lorie Logan believes that the federal funds rate target is outdated, as the interbank market utilization it relies on is low, and its connection to the broader overnight money market is "fragile" and "could suddenly break."

She suggested that updating the mechanism for the Federal Reserve's monetary policy implementation would be part of "efficient and effective central banking."