Since June 2022, the Federal Reserve has been reducing its balance sheet to restrict liquidity in financial markets in response to elevated inflation levels. Initially, the Fed reduced its monthly reinvestments by $60 billion in U.S. Treasuries and $35 billion in mortgage-backed securities (MBS), amounting to a total reduction of $95 billion per month. By June 2024, the Fed announced a slowdown in its balance sheet reduction pace, lowering the amount of U.S. Treasuries not reinvested to $25 billion per month, bringing the overall reduction amount down to $60 billion.

The Fed’s balance sheet size has decreased from a peak of approximately $9 trillion in May 2022 to around $7 trillion currently. Following the Fed’s decision to cut rates by 50 basis points in September 2024, discussions about potentially halting balance sheet reductions have intensified. Market attention has focused on the Fed’s overnight reverse repurchase (RRP) operations, which have seen volumes decline steadily. This tool allows the Fed to absorb excess liquidity by selling securities to counterparties and repurchasing them the next day.

Read more at Datatrack

The volume of overnight RRP operations reached a peak of $2 trillion during 2022-2023 but has since fallen to below $200 billion, indicating a steady reduction in excess liquidity within the financial system. This trend has raised concerns among market participants about potential tightening of market liquidity if the decline continues.

However, an examination of the Fed’s balance sheet structure reveals that, despite the decline in RRP volumes to approximately $144 billion, reserves held by banks at the Fed remain at a historically high level of around $3.2 trillion. Therefore, market expectations of continued rate cuts by the Fed suggest that overall liquidity remains sufficient.

Read more at Datatrack

Additionally, in October 2024, the Fed introduced a new liquidity monitoring tool—the Reserve Demand Elasticity (RDE) indicator. A lower RDE value implies that changes in reserve demand have a more significant impact on interest rates, signaling tighter reserves. Current data shows that the RDE remains near zero, indicating stable liquidity conditions. Moving forward, attention will be focused on whether the Fed adjusts or halts balance sheet reductions before the depletion of RRP operations.

(Source: Federal Reserve Bank of New York)