Fed Rate Cut Uncertainties Stir Concerns Over Balance Sheet Drawdown

Uncertainty over the size of an expected Federal Reserve (Fed) interest rate cut on Wednesday has sparked debate about whether the central bank might accelerate the end of its balance sheet drawdown, known as quantitative tightening (QT).

Speculation is growing in rate futures markets that the Fed might opt for an opening cut of 50 basis points rather than a smaller 25 basis points reduction. A larger cut could signal concerns about the economic outlook, potentially shortening the duration of QT.

QT is generally viewed as a liquidity management tool separate from the Fed's interest rate policy, which aims to curb inflation without overly impacting the labor market. However, more aggressive rate cuts could be seen as conflicting with tighter liquidity, depending on the reasons behind the rate reductions.

An accelerated end to QT would mark a significant shift in the Fed's balance sheet strategy. A survey of major banks by the New York Fed in July indicated expectations for QT to conclude in April 2025. However, Fed officials have suggested there is room to continue QT for the time being.

"If they ease rates by 50 basis points, the decision about the balance sheet becomes more complex," said Patricia Zobel, a former manager at the New York Fed, now at Guggenheim Investments. While Zobel anticipates a quarter-point cut with QT continuing, she acknowledges the potential for an earlier end to QT if economic concerns grow.

Balancing Rate Cuts and QT

The Fed currently targets the fed funds rate in a 5.25% to 5.50% range. Matthew Luzzetti, an economist at Deutsche Bank, suggests that a significant rate cut paired with signals of further aggressive easing could create conflict between reducing rates and continuing the balance sheet drawdown.

Bank of America analysts also believe a half-point rate cut aimed at supporting the economy would likely lead to an early end to QT.

The current uncertainty reflects whether the Fed will cut rates merely to normalize borrowing costs amid declining inflation, or whether deeper concerns, such as a potential slowdown in the labor market, are driving the decision.

QT's Trajectory and Market Liquidity

The QT process, now over two years old, began as the Fed transitioned to rate hikes to combat inflation. Since the summer of 2022, the Fed has reduced its holdings by about US$1.8 trillion after peaking at US$9 trillion in Treasury bonds and mortgage-backed securities. The drawdown aimed to scale back pandemic-era stimulus without disrupting market stability.

QT discussions have primarily focused on maintaining sufficient liquidity in the financial system to manage normal short-term rate fluctuations and maintain control over the fed funds rate. Former New York Fed President William Dudley noted that QT is unlikely to end until the Fed believes it has moved from "abundant reserves to ample reserves."

James Bullard, former St. Louis Fed leader and now dean of Purdue University's business school, emphasized that QT and interest rate policy remain aligned for now, even with potential rate cuts. He suggested that QT might only end when the funds rate reaches around the neutral level, estimated to be 3% or lower.

Analysts at LH Meyer argue that any move to a fed funds rate of 3% or lower could be a trigger for ending QT, aligning the Fed's dual policy tools.