Debt Limit Dynamics and the Federal Reserve Balance Sheet: Time for a QT Change?

The debt ceiling in the United States was reinstated earlier this year. In line with the experience of previous debt ceiling episodes, the U.S. Treasury is currently taking various actions to prevent a government default. One such action is to reduce the balance Treasury General Account, TGA below the target level set by the Treasury Department. This reduction in the TGA balance has a direct impact on the balance sheet Federal Reserve.

The reduction in the TGA balance automatically increases the amount of liquidity in the financial system. Based on past experience, we can expect at least some of this excess to be reflected in higher levels of bank reserves, while the rest will go to overnight reverse repo operations (ON RRP). While this is not a problem at the moment, these increased reserve levels are “artificial” in the sense that they result from a temporary redistribution of the Fed’s liabilities and are likely to reverse quickly.

After the debt ceiling is resolved, the Treasury Department will likely seek to rebuild the TGA balance to levels considered appropriate. Recent experience suggests that such rebuilding can be significant and rapid. For example, after the debt ceiling was suspended in early June 2023, the TGA balance, which had previously declined to almost zero, increased by $600 billion in just three to four months.

A rapid recovery of the TGA will bring a proportionate and equally rapid decline in the Fed’s other liabilities. In the 2023 debt ceiling episode, high levels of ON RRP drawdown offset almost the entire increase in TGA following the ceiling suspension—bank reserves were not materially affected at that time. However, with ON RRP resources largely depleted and the Fed’s balance sheet reduction still ongoing, bank reserves may be much more exposed to the impact of the TGA recovery. This introduces an obvious risk that reserves could fall sharply to levels close to or below those that policymakers consider desirable. In such a scenario, reserve condition indicators would continue to play their role, but they may not provide an early warning.

Put simply, the longer the Fed’s balance sheet reduction continues in the midst of the debt ceiling, the greater the risk that once the debt ceiling is resolved, reserves could quickly fall to levels that trigger significant volatility in money markets.

As noted in the minutes of the January meeting FOMC in 2025, various participants thought it might be appropriate to consider pausing or slowing balance sheet reduction until the debt ceiling situation was resolved.

Will this reduction or pause in QT take place as early as March 19? It cannot be ruled out, because sooner or later the Fed will have to reduce QT or stop them. This could have consequences for financial markets, first and foremost for the dollar or treasury bonds, and then it could also affect risky assets.