The era of aggressive balance sheet reduction by the US Federal Reserve, known as quantitative tightening (QT), appears to be drawing to a close. Despite calls from some quarters for the Fed to shrink its holdings further, the practical benefits are minimal and the risks are growing. This shift in strategy has significant implications for global financial markets and economic policy.
The Journey from Abundant to Ample Reserves
The Fed's balance sheet has undergone a substantial contraction since its pandemic peak. From a high of $8.97 trillion in April 2022, it has been reduced to $6.56 trillion as of late 2025. This unwind of Treasury and mortgage-backed security purchases has successfully moved the banking system from a state of "abundant" reserves, where supply perpetually exceeded demand, to the current "ample" regime. Here, demand for reserves can occasionally outstrip supply, causing subtle shifts in money market rates.
This tightening in reserve conditions is already visible. Over the past two months, the federal funds rate has drifted five basis points higher within its target band. Furthermore, repo rates have frequently exceeded the rate offered by the Fed's Standing Repo Facility (SRF), prompting banks to utilise this safety valve. Fed Chair Jerome Powell has publicly endorsed this "ample reserves" framework, signalling a major policy commitment.
Why Further Shrinkage is Impractical and Risky
Advocates for a smaller balance sheet argue it could reduce the Fed's market footprint, increase rate volatility to better gauge stress, and potentially allow for deeper rate cuts. However, this view overlooks critical complexities. Achieving a meaningfully smaller balance sheet would require a fundamental and disruptive overhaul of monetary policy operations.
The core mechanism would involve making bank reserves less attractive than other assets, like Treasury bills. To force this shift, the Fed would need to either raise the SRF rate or scrap the facility entirely. As reserves became scarcer, money market rates would rise and become more volatile. Banks would then hold more Treasury bills and fewer reserves.
While technically possible, the transition would be fraught with difficulty and the benefits are strikingly modest. The primary gain would be eliminating a minor subsidy where the interest on reserves (currently 4%) slightly exceeds the yield on short-term Treasuries (around 3.95%). Analysts estimate this would save the US government a mere four to five basis points in funding costs—a pittance against a $2 trillion annual deficit.
The Fed's New Path: Maintaining Ample Reserves
Recognising these limited upsides, the Fed is poised to end quantitative tightening imminently. Instead, it will begin a new phase of modest Treasury purchases to keep reserves at an "ample" level and prevent them from becoming "scarce." This is necessary to offset two structural drains: growing demand for physical currency and expanding bank balance sheets.
Currency in circulation is rising about 3% annually, which could necessitate roughly $70 billion in Treasury buys in 2026. If bank reserve demand grows in line with nominal GDP (around 4%), an additional $115 billion in purchases may be needed. Combined, this totals less than $200 billion per year—a trivial amount compared to the scale of public debt. The Fed will also continue rolling mortgage-backed securities proceeds into Treasuries.
Ultimately, monetary policy restraint is dictated by the level of short-term interest rates, not the size of the balance sheet. Therefore, a smaller Fed portfolio would not exert additional economic braking power or enable significantly lower rates. The pursuit of further QT offers little reward for considerable risk, cementing the Fed's commitment to its current, stable regime.
