US Central Bank prepares to end monetary tightening

The increase in the search for liquidity exposes the tension in the financial system and pressures the Federal Reserve to rethink the pace of its downsizing program

The Federal Reserve (Fed), the central bank of the United States, is about to end one of the longest phases of monetary tightening in its recent history. After three years of reducing its gigantic balance sheet, the institution is expected to begin this week a crucial debate on the end of the so-called Quantitative Tightening (QT) — the liquidity drying process that began in 2022 and that removed more than US$2 trillion in Treasury bonds and mortgage-backed securities from the financial system.

The discussion comes at a time of growing concern about the scarcity of resources in money markets. In recent days, banks have once again turned to the Fed’s emergency funding mechanisms at levels not seen since the height of the Covid-19 pandemic — a sign that liquidity may be becoming tighter than desirable.

Talks between monetary policymakers officially begin next Tuesday, and the consensus among analysts is that the tightening cycle is close to an end. “It quickly became almost a consensus that the Fed will end QT this month,” said Krishna Guha, vice president at consultancy Evercore ISI.

Former Fed vice president and current Pimco economist, Rich Clarida, reinforced the assessment: “It’s a difficult decision. Even if we don’t have a formal decision, we will have a strong indication that they will end the program in December.”

At the beginning of the month, central bank president Jay Powell had already signaled that QT would be ended “in the coming months”. Powell also indicated his intention to cut the benchmark interest rate again by 0.25 percentage points, which would mark the second consecutive cut.

The financial markets, attentive to these signs, have already practically completely priced in the expectation that the interest rate will fall to the range between 3.75% and 4% in the decision scheduled for Wednesday. This movement occurs amid signs of weakening in the North American labor market and reduced fears that the trade war waged by former president Donald Trump will once again put pressure on inflation.

On the one hand, QT; on the other, QE

QT represents the opposite of the policy of Quantitative Easing (QE) — or quantitative easing — used by the Fed during periods of crisis, such as during the pandemic and after the collapse of Lehman Brothers in 2008.

In QE, the central bank buys bonds and financial assets, injecting liquidity into the economy and stimulating credit. In QT, the Fed does the opposite: it allows securities on its balance sheet to expire without being replaced, draining money from the system and increasing financing costs.

Since the beginning of the current cycle, in June 2022, the Fed has been gradually reducing the volume of assets in its portfolio. In April, it slowed the pace of tightening, reducing monthly sales of Treasury securities from $25 billion to $5 billion, while maintaining the pace of up to $35 billion in mortgage-backed securities.

This strategy has a direct impact on banks, which end up with fewer reserves available at the Fed and are therefore more vulnerable to fluctuations in funding rates.

Fear of repeating 2019

Central bank officials had already agreed that the program would be halted as soon as the U.S. banking system transitioned from a condition of “abundant liquidity” to a regime of “ample” reserves — an equilibrium point where there is enough money to ensure stability, but not too much.

While signs of widespread stress are limited, recent use of the New York Fed’s permanent repo facility — an emergency tool with rates above benchmark rates — has reached levels similar to those seen during the Covid-19 crisis.

“Evidence from financial markets indicates that you are very close to moving from abundance to plenty, or perhaps you have already gotten there,” said Guha.

Economists also warn that the Fed seeks to avoid a new episode like that of September 2019, when the liquidity squeeze caused short-term rates to soar, generating panic in the markets. “The main issue guiding the Fed’s thinking is the fear of a liquidity shock,” explained Diane Swonk, chief economist at KPMG in the United States.

A still giant swing

Even with recent advances, the Fed’s balance sheet remains high: US$6.59 trillion — more than US$2 trillion above the pre-pandemic level. Before the 2008 financial crisis, that number was less than $1 trillion.

For Swonk, the task of reducing the balance sheet is not simple. “You can’t just reduce the balance sheet balance as easily as you can expand it. The overnight lending market that existed before the financial crisis no longer exists,” she said.

The Fed’s liquidity expansion and contraction policies, while effective in preventing financial meltdowns, have been criticized. US Treasury Secretary Scott Bessent even classified the QE program as an “undue expansion of objectives”, arguing that it contributed to widening social inequality — an accusation rejected by central bank directors.

With the US economy showing mixed signals — slowing inflation, but moderate growth and tighter credit — the end of QT could mark a turning point in American monetary policy. The debate that begins this week promises to define not only the Fed’s direction, but also the tone of global markets in the coming months.