Bank reserves could fall by $2.5 trillion as the Fed reduces its balance sheet, Fitch Ratings says

• Bank reserves could fall between $900 billion to $2.5 trillion by year's end, Fitch Ratings said.
• That's as the Fed's quantitative tightening dries up liquidity in the banking system.
• "Tighter liquidity could exacerbate the ongoing shift to more restrictive credit conditions, weighing on US growth."

The Federal Reserve's quantitative tightening measures could take trillions of dollars from the banking system and intensify a credit squeeze, Fitch Ratings said Friday. 

"System-wide banking liquidity indicators are still robust, but our baseline projection is for reserves to fall significantly by USD900 billion to USD2.5 trillion by year-end," the ratings agency said.

Fitch added that this process could be sped up if usage rises for the Fed's reverse repo facilities — in which the Fed sells securities to later repurchase them at a higher price, temporarily absorbing cash from financial institutions.

In addition to raising interest rates, QT is another means by which the Fed can slow the economy to rein in inflation. It aims to soak up excess liquidity in the economy by reducing the central bank's balance sheet.

This is done by allowing matured government bonds to "run off," rather than reinvesting them. When it began trimming its balance sheet in June, the Fed held almost $9 trillion in such assets.

But paired with March's banking rupture, QT risks fueling a credit crunch. For now, liquidity in the banking system is strong, Fitch said, as lenders benefited from prior quantitative easing policies, during which the Fed bought massive amounts of securities to fuel the economy. Reserves hit $4.2 trillion in 2021 after QE for Covid-19 response.

But concerns of a credit crunch have been on a steady rise since the Silicon Valley Bank collapse in March, which exposed vulnerabilities in the banking system and caused many depositors to withdraw their money.

While many took their funds out of smaller lenders and into "too big to fail" banks, money markets also saw an ample increase in funds. 

"QT will also put downward pressure on bank deposits, boosting the system-wide loans-to-deposits ratio," Fitch said. "Tighter liquidity could exacerbate the ongoing shift to more restrictive credit conditions, weighing on US growth."