—a seemingly dull 'operational note' that releases multiple significant signals
As President Trump stages a 'beauty contest' for selecting the new Federal Reserve Chairman, it might be worth considering the successor to the soon-to-be-retiring Powell: he may inherit a 'hot potato' that is not very dignified.
Just last week at the Federal Open Market Committee (FOMC) meeting, the Federal Reserve was once again pulled back onto the path of **quantitative easing (QE)**.
After the meeting, most external attention was focused on Powell's announcement of the interest rate cut—this is the sixth rate cut since September 2024, with a cumulative reduction of 1.75 percentage points. But an equally important decision, which has been overlooked, is hidden in a dry 'implementation note':
The Fed will purchase about $40 billion in short-term Treasury securities over the next month, and may continue making purchases of a similar scale each month until at least next April.
There is good reason to believe that once the Fed starts expanding its balance sheet again, it is unlikely to stop anytime soon.
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A systemic shift beneath the guise of “technical adjustments”
The Fed describes this move as a “technical adjustment” to the financial system reshaped in the wake of the 2008 financial crisis. But the heart of the issue is not on the asset side; it is on the liability side—in other words, the changing structure of the Fed’s balance sheet itself.
After the 2007–2008 financial crisis, the Fed rapidly expanded its assets by purchasing large quantities of U.S. Treasury securities and mortgage-backed securities (MBS). These assets had to be matched by liabilities, and the easiest liabilities to expand were the reserve accounts that commercial banks hold at the Fed.
In other words, the Fed “creates money out of thin air” to buy bonds, and that money ultimately sits in commercial banks’ accounts in the form of reserves.
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A whole new monetary cycle has been established
In effect, this approach has created an entirely new monetary cycle between the Fed and commercial banks.
Before quantitative easing, commercial banks had many ways to obtain liquidity reserves, including lending to one another in the overnight interbank market. But after QE was implemented, the Fed wanted banks to meet their liquidity needs by holding higher reserve balances at the central bank.
The word “want” is deliberately vague here. On the one hand, the Fed projects that banks may prefer the greater safety of reserves because of stricter capital regulations. On the other hand, regulatory pressure and the system of interest paid on reserves are also effectively pushing banks to hold more reserves whether they want to or not.
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The hidden costs of the “ample-reserves regime”
This so-called “ample-reserves regime” has far-reaching consequences that are difficult to quantify.
Because of the way financial regulations treat reserves in risk calculations, high reserve levels may actually:
• Discourage banks from lending to the real economy (Main Street);
• Make banks less willing to participate in Treasury trading.
And now, an even more serious risk is emerging:
The Fed is gradually losing control of its own balance sheet.
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No one can say where the “safe line” for balance-sheet runoff lies
The problem is that when the Fed tries to shrink its balance sheet through “quantitative tightening” (QT), its liabilities must contract at the same time, which means commercial banks’ reserve balances will fall.
But one key question remains unanswered:
How low can reserves fall before banks start to feel they are “running short”?
No one can answer that precisely.
Once reserves fall below banks’ perceived or regulatory safety threshold, banks rush into the interbank lending market to compete for funds. This can cause overnight rates to surge, even far above the Fed’s target for the federal funds rate.
This already happened in the fall of 2019. The Fed is now clearly worried that similar market turmoil could happen again.
So last week, it chose to buy Treasury securities again and expand its balance sheet to keep reserve balances from “falling below the red line.”
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Not calling it QE doesn’t mean it isn’t QE
The Fed is trying to portray all this as a purely technical issue, as if it had nothing to do with the direction of macroeconomic policy. But whether or not it uses the term “quantitative easing,” the economic reality remains the same.
The fact is:
The Fed has resumed asset purchases even as it continues to claim that “fighting inflation” is its top priority.
And such operations are bound to affect interest rates, financial conditions, and even inflation expectations.
At the same time, this also reveals another reality of the “ample-reserves regime”:
Under this system, the Fed’s balance sheet must remain at an extremely high level relative to the size of the economy over the long term. A balance sheet roughly equal to 20% of GDP now seems to have become the new “minimum requirement.”
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The real concern is “who’s in the driver’s seat”
Even more unsettling is a nagging intuition:
The Fed’s balance-sheet policy is being determined passively by markets and banks.
For more than a decade, central banks first set targets for the size of their assets, then adjusted the composition of their liabilities accordingly. But now, the reverse seems to be happening—
Commercial banks need only increase their demand for reserves to “force” the Fed to buy Treasury securities.
If not, how else can we explain:
A form of “passive QE” triggered by the risk of volatility in the interbank market?
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Alternatives to the current system do exist
In fact, alternatives to the “ample-reserves regime” do exist, but have been left for future discussion. Among the current candidates for Fed chair, **Kevin Warsh** seems most willing to abandon this framework.
If Trump ultimately selects a new chair, overhauling the framework for monetary operations may be an important undertaking worth pursuing.