Warning signs in short-term funding markets are putting pressure on the Federal Reserve to stop shrinking its massive balance sheet — the pile of Treasuries and mortgage-backed securities it built up during years of economic support, The New York Times reports.

For the past several years, the Fed has been reducing its holdings through a process called quantitative tightening (QT). This reverses the earlier quantitative easing (QE) programs, where the Fed bought bonds to inject money into the financial system and keep borrowing costs low during crises like 2008, 2019, and 2020.

As the Fed sells or lets bonds mature, money flows out of the financial system, tightening liquidity. That’s starting to create stress in the short-term “money markets” — where banks and investment funds borrow and lend cash overnight to keep daily transactions running smoothly. These markets are critical to the financial system’s plumbing.

Recently, overnight borrowing rates have spiked as demand for cash has exceeded supply, showing that liquidity is getting tight. The Secured Overnight Financing Rate (SOFR) — a key measure of short-term funding costs — even moved above the Fed’s target range, something that rarely happens. This raised alarms similar to the 2019 cash crunch, when the Fed had to intervene quickly.

The Fed’s balance sheet peaked near $9 trillion in 2022 and is now down to $6.6 trillion. Bank reserves — the cash banks keep on deposit at the Fed — have dropped from over $4 trillion to just above $3 trillion. Analysts think that if reserves fall much further, it could trigger another liquidity squeeze.

Fed Chair Jerome Powell has acknowledged that the system’s liquidity is “gradually tightening,” signaling that QT could end soon. Some analysts think the Fed may even need to start buying securities again next year to stabilize reserves and ensure there’s enough cash in the system.

Is the Fed doing the right thing? The answer is: It’s a delicate balance.

On the pro side, reducing the balance sheet helps fight inflation by tightening money supply and credit conditions. It also signals confidence that the economy no longer needs extraordinary support.

But on the con side, shrinking too far risks liquidity shortages — as we’re now seeing. If banks can’t easily access cash, short-term rates spike and markets get unstable, even if inflation is under control.

Nevertheless, most analysts now believe the Fed has gone far enough with QT and should pause soon, possibly this week, to avoid another money-market crisis.

As TD Securities’ Gennadiy Goldberg put it, “The end of QT is near.”