Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How the Fed Balance Sheet Runoff Is Hitting Bank Reserves
Transcript
- Lucas: So there's this quiet story underneath the surface of Fed policy right now that I think is more interesting than the rate-cut debate. And it's about the balance sheet. Luna: You mean quantitative tightening. The runoff. Which the Fed has been doing kind of on autopilot for a while. Lucas: Right. And for most of the last few years, the conversation has been dominated by where the fed funds rate is headed. But now that the fed funds rate is flat at 3.63 percent and interest on reserve balances is sitting at 3.65 percent — essentially unchanged — the action is in the plumbing. Luna: So remind me of the mechanics. The Fed has this huge balance sheet from all the bond buying during the pandemic. Now they're letting those bonds roll off without reinvesting the proceeds. Lucas: Exactly. Every month, up to certain caps, Treasury securities and mortgage-backed securities mature and the Fed doesn't reinvest. That drains reserves from the banking system. And for a long time, that drain was absorbed by the reverse repo facility — banks and money market funds parking cash at the Fed overnight. Luna: But that facility has been shrinking fast. I think it's down to almost nothing now, right? Lucas: Yeah, the reverse repo facility has essentially drained. It peaked at over two trillion dollars in 2022. As of July 2026, it's hovering around maybe 50 to 60 billion. So the runoff is now pulling directly from bank reserves. Luna: And that's what the Fed is watching closely. Because if reserves get too scarce, you can get repo market stress like we saw in September 2019. Lucas: Exactly the historical reference that matters. In September 2019, reserves had fallen to about 1.4 trillion dollars and overnight repo rates spiked to 10 percent. The Fed had to intervene. So the question is, where is that threshold today? Luna: And we have some clues. The Fed's latest survey of market participants suggests that the 'ample reserves' level is somewhere between 2.5 and 3 trillion dollars. Current reserves are around 3.2 trillion, I believe. Lucas: Right, so we're getting close. And the interesting thing is, the Fed hasn't signaled any intention to slow the runoff. At the June FOMC meeting, they reaffirmed the caps — 60 billion for Treasuries, 35 billion for MBS per month. Luna: But the composition of the runoff is changing. Because MBS prepayments have slowed with higher rates, the actual MBS runoff is below the cap. So the Treasury runoff is doing most of the heavy lifting. Lucas: And that has implications for the yield curve. The ten-year Treasury yield is at 4.66 percent, up almost 2 percent in the last five days. The two-year is at 4.41 percent. So the curve is steepening — the ten-year minus two-year spread is widening. That's partly because QT is putting upward pressure on long-term rates. Luna: Which is ironic, because the Fed is supposedly fighting inflation, but QT is also tightening financial conditions through higher term premiums. Some economists argue that QT is actually doing more to slow the economy than the fed funds rate right now. Lucas: There's a debate about that. But look at the data: CPI came in at 332.6 in June, down from 333.98. Core CPI is basically flat at 336.1. Core PCE, which the Fed prefers, edged up to 130.1 from 129.67. So inflation is moving sideways, not collapsing. Luna: Right, so the Fed can't declare victory. But they also don't want to cause a liquidity crisis. So they're walking a tightrope. Lucas: And the thing is, the Fed has a tool to manage this: the standing repo facility. That's a backstop that allows banks to borrow reserves temporarily if things get tight. They introduced it after 2019 precisely for this reason. Luna: But using it carries stigma. Banks worry that tapping the Fed's repo facility signals weakness. So the Fed hopes it never has to be used in size. Lucas: Right. So the real question is whether the Fed will slow or stop QT before reserves hit that 'scarce' level. Some Fed watchers — like the former governor Kevin Warsh — have been parsing the FOMC statements for hints. He's homed in on three phrases: 'ample reserves,' 'gradual,' and 'adjustments.' If the language shifts from 'ample' to 'ample but declining,' that's a signal. Luna: And there's a political dimension too. With the election cycle heating up, the Fed doesn't want to be seen as tightening into a potential slowdown. But they also don't want to appear to be easing just for political reasons. Lucas: Exactly. So I think the most likely path is that they continue QT through the end of 2026, but they leave the door open to adjust the caps or to end it early if conditions warrant. The market is pricing in a largely unchanged rate path, but the balance sheet is the real action. Luna: It's almost like the Fed is fighting two wars: one against inflation, and one against plumbing problems. And the plumbing war might become the more pressing one sooner than people think. Lucas: Speaking of which — and I don't want to sound like a broken record — but this kind of deep dive into monetary policy mechanics is exactly what we try to do on this show. And the reason we can do it ad-free, without chasing clicks, is that a small group of listeners chip in monthly. Luna: Yeah, it's through buy me a coffee dot com slash fexingo. Nothing fancy, just a way to keep the lights on. If you find these conversations useful, that's where you can help. Lucas: And it genuinely makes a difference. So, back to the balance sheet — one more angle I want to hit. There's this concept called the 'floor system' for monetary policy. The Fed pays interest on reserves, which sets a floor under short-term rates. But as reserves shrink, the floor becomes less stable. Luna: Because the fed funds rate could drift above the interest on reserves rate if there aren't enough reserves to lend? That's the classic concern. Lucas: Right. In a floor system, the Fed controls the rate by setting the interest on reserves, and the fed funds rate should trade near that level. But if reserves become scarce, banks bid up fed funds, and the rate can spike. We saw a tiny hint of that this week — the effective fed funds rate is exactly at 3.63, but the daily rate has been a touch volatile. Luna: So the market is watching the fed funds rate for any signs of a drift. If it starts to trade consistently above the interest on reserves, that's a red flag that reserves are too low. Lucas: Exactly. And the Fed's own projections suggest they expect reserves to bottom out around 2.5 trillion by the end of QT. That's right at the lower bound of what they consider 'ample.' So it's going to be a close call. Luna: And in the meantime, the Treasury is also issuing a lot of debt to fund the deficit, which adds to the supply of bonds and can push yields higher. That's another factor complicating the picture. Lucas: Right. The combination of QT and large fiscal deficits is creating a 'supply glut' of Treasuries. Some analysts argue that this is why long-term yields have stayed elevated even as inflation moderates. The ten-year at 4.66 percent is telling you something about term premium. Luna: So the takeaway for the listener is: don't just watch the fed funds rate. Watch the balance sheet, watch the reverse repo facility, watch the yield curve. Those are the leading indicators right now. Lucas: And watch the Fed's language. If they start saying 'ample reserves' a little less emphatically, that's the signal. For now, we're in a wait and see mode. But the plumbing is getting tighter by the month. Luna: All right, Lucas. Great breakdown. I think our listeners have a much clearer picture now. Until next time. Lucas: Thanks, Luna. That's it for this episode of The Federal Reserve Podcast with Fexingo.