The Federal Reserve's decision to suspend long-term balance sheet cuts could have a more significant impact on financial markets in the medium term than the central bank's interest rate trajectory.
On Wednesday, the Fed cut interest rates by 25 basis points to a range of 3.75%-4%, as expected, although prospects for the trajectory of borrowing costs in the near term remain murky due to a lack of new economic data during the ongoing federal government shutdown.
Separately, policymakers also announced an end to the December 1 reduction in Treasury bonds and mortgage-backed securities, a process known as quantitative tightening.
After rapidly expanding the size of its balance sheet to support markets and the economy during the COVID-19 pandemic, the Fed has been reducing its assets for most of the past three years. Having peaked at almost $9 trillion in 2022, the balance sheet has now shrunk to about $6.6 trillion.
However, this reduction threatened to drain a significant portion of the liquidity needed to keep the financial market running. The impact of this dynamic became apparent in the short-term money markets this month, as banks and other participants searched for more cash than was available for lending. As a result, one-day interest rates rose, at some point exceeding the Fed's target range.