Part 5/12:
Despite the economic growth in recent years, the financial system depends heavily on adequate reserves and liquidity. A shrinking balance sheet reduces reserves, potentially causing the repo rates (short-term borrowing costs between banks) to spike, risking instability in short-term funding markets. Past crises, such as the repo market disruptions in 2019 and the financial stress during early 2020, underscore how fragile this system can be when liquidity wanes.
The Federal Reserve’s current strategy involves halting balance sheet reductions, not out of concern for economic overheating but to maintain the plumbing of the financial system. If there aren't enough reserves, short-term funding markets could seize up, causing yields to spike and financial assets to become unstable.