Fed balance sheet update

Stephen Stanley | December 12, 2025

This material is a Marketing Communication and does not constitute Independent Investment Research.

The FOMC announced at its recent meeting that it would start expanding its balance sheet on December 12. That should make the Fed going forward a consistent and sizable buyer of Treasury bills and perhaps some shorter coupons. Beyond its effect on repo markets, the Fed action gives the US Treasury more room to rely on bills to fund federal spending.

A quick turnaround

Less than three months ago, the FOMC decided to continue reducing its balance sheet with little indication of an imminent shift.  Then, money market rates began to rise in October, sparking alarm at the central bank. The FOMC decided in October to stabilize the balance sheet beginning on December 1. The original plan had been for that move to be followed by a transition period where the balance sheet size would remain unchanged for a while before a return to growth.  As it turns out, that transition lasted 11 days.

Balance sheet strategy

After the Global Financial Crisis and again during the pandemic, the FOMC was forced to slash its policy rate to the effective zero bound, leaving it with no room to inject further stimulus into the economy via interest rates.  In both cases, the Fed sought to add more liquidity by purchasing securities, expanding the balance sheet.  Once the emergency was past, the Fed reversed course and winnowed down the size of the by-then bloated balance sheet.

In 2019, the Fed famously overshot, removing too much liquidity and causing a significant disruption in the repo market that required large injections of liquidity to smooth over.  As a result, officials have been intent not to repeat the same mistake in reducing the balance sheet this time around.

As a result, at the first sign of trouble in October, the FOMC abruptly ended its balance sheet reduction, after the end of November. This entailed halting the $5 billion monthly runoff in maturing Treasury securities and replacing the redemptions in its MBS portfolio, which typically amount to around $15 billion a month, with purchases of Treasury bills.

As noted above, the gameplan that the Fed had previously published regarding the balance sheet end game involved stopping the contraction somewhat before the balance sheet reached the appropriate size and then allowing the economy and the demand for liquidity to grow into ultimately matching the new balance sheet size.  However, Fed officials were clearly alarmed by the persistence of elevated money market rates in November and early December, likely concluding that, despite their best efforts, they may have overshot again, as they did in 2019.

At the December FOMC meeting, the committee ended the transition period and voted to begin growing the balance sheet right away as opposed to the delayed implementation seen in October.

The FOMC changed its operating systems for regulating bank reserves in 2008, when Congress authorized the payment of interest on reserves.  The Fed shifted to what it calls an ample reserves regime, where the Fed seeks to maintain plentiful liquidity and use administered rates—the interest on reserves rate, the RP rate, and the reverse RP rate—to keep money market rates squarely inside of the fed funds target range as opposed to the pre-2008 norm of precisely calibrating the level of reserves to hit the funds rate target.

Financial market participants do not have much experience with a “normal” ample reserves balance sheet regime, because the Fed has either been conducting QE, expanding the balance sheet, or unwinding via QT, reducing the balance sheet, for all but a few months of the past 17 years. So, a quick primer on what the landscape is supposed to look like is in order.

Liquidity should match the economy

The liquidity demands of the economy should grow in rough tandem with the nominal expansion of activity.  If the current level of the Fed’s balance sheet, about $6.6 trillion including the securities portfolio of $6.24 trillion and other sources of funds, is appropriate for the economy, then we might presume that the Fed’s balance sheet would need to grow by around 4% to 4.5% a year, which is about what the FOMC economic projections suggest for nominal GDP growth going forward.  That would work out to about a $250 billion to $300 billion annual increase. Chair Powell confirmed this rough calculation, as he indicated yesterday that the FOMC believes that the balance sheet would be expected to expand by around $20 billion to $25 billion a month.

Note that this is what is necessary just to match the growing demand for liquidity.  The balance sheet expansion announced on Wednesday is quite different than QE.  The goal here is not to stimulate the economy but merely match the evolving demand for bank reserves over time.

There is one additional twist to the story.  The demand for liquidity has a substantial seasonal element.  In particular, it traditionally builds in the run-up to April 15, as businesses and households drain money out of the financial system to pay their taxes.  As a result, in an effort to lean against the usual seasonal decline in bank reserves in the early part of the year, the Fed announced yesterday that it will purchase securities at a faster pace in the next few months and then slow down after April 15.

In particular, Treasury bill purchases to expand the balance sheet will be $40 billion in the mid-December to mid-January period and will “remain elevated for a few months.”  This means that the tempo of outright purchases will likely slow markedly after April.  Taking the midpoint of Powell’s $20-$25 billion per month range would imply $270 billion in annual purchases.  If the Fed buys $40 billion per month in each of the next four months, that would be $160 billion, leaving only $110 billion to be spread over the following eight months.

Operational details

In all, the Fed will be buying $55 billion in Treasury bills over the next month, $15 billion to replace MBS runoff and $40 billion to expand the balance sheet.  The Wednesday announcement noted that the Fed could sometimes buy coupon securities maturing in three years or less for its outright purchases, but would “generally” stick to bills, shifting only if market conditions dictated a change.

The New York Fed released the first monthly schedule on Thursday.  The $55 billion in purchases over the first month of the new regime will be all in Treasury bills.  There will be seven operations, hitting the shorter portion of the bill sector (one to four months outstanding) five times for $8.17 billion each and the longer end of the bill curve (four to 12 months) twice, at $6.8 billion each.  The purchase sizes were worked out to be proportional to outstanding debt in each sector.

Broader Implications

Money market conditions have gradually been tightening from a state of massive excess liquidity over the past few years.  The bulk of this evolution has come from the shrinkage in the reverse RP facility, which at its peak was taking in well over $2 trillion a day and is now running at minimal daily levels.  The shift to a steady injection of liquidity by the Fed will be interpreted by some as a form of stimulus.  However, if the Fed has gotten its assessment of money market conditions correct, then its interventions should be viewed as passively tracking the natural upward trend in the demand for liquidity, neither loosening nor tightening money market conditions.  We will have to see whether the Fed has indeed nailed it.

One area where the Fed’s shift will have meaningful implications is the Treasury financing outlook.  With the Fed committing to buying close to $450 billion a year in bills—$270 billion in outright purchases and $180 billion to replace MBS runoff—the supply of bills available to the public will be reduced on a one-for-one basis assuming constant issuance.  Of course, issuance is not constant.  Given nearly $2 trillion annual budget deficits, the Treasury will need to increase its borrowing steadily over the next few years.  The question has always been whether the Treasury would fill its incremental borrowing need through bills only or a mix of bill and coupon auction size hikes.  At the margin, the Fed’s actions will likely push the Treasury to rely more heavily on bill size increases.