Fed Navigates Blind Spot as Shutdown Disrupts Data, QT Halts and Rate Cuts Loom

The Federal Reserve's balance sheet normalization appears to be nearing completion, with the central bank poised to halt QT and announce a 25-basis-point rate cut in October, according to officials and market signals. These moves come amid growing stress in money markets and a government shutdown that has disrupted critical economic data collection, complicating the Fed's ability to assess inflation and labor market conditions.

The Fed's decision to end QT follows months of tightening liquidity conditions, particularly in the repo market, where the spread between the Secured Overnight Financing Rate (SOFR) and the federal funds rate hit a record 10 bps last week. "The Fed is ready to stop QT to address tighter liquidity conditions and stabilize funding markets," Chair Jerome Powell stated on October 14. By halting QT, the Fed aims to replenish bank reserves and ease upward pressure on repo rates, which have surged due to aggressive Treasury bill issuance and the Treasury's efforts to rebuild its cash balance post-debt-ceiling agreement.

The rate cut, widely anticipated by economists and traders (with a 98.9% probability on the CME FedWatch tool), reflects cooling inflation and a fragile economic outlook. September CPI data showed year-over-year inflation at 3.0%, below expectations, while core CPI rose 3.0% annually, marking a slowdown from recent peaks. However, delayed data from the government shutdown has created uncertainty, with the next inflation report-typically a key policy guide-likely absent for the first time in over 70 years. This lack of data has left the Fed navigating a "blind spot," as it grapples with the risk of a recession amid a labor market showing signs of weakening.

The Fed's stress test reforms, announced amid a lawsuit from banking and business groups, also underscore its balancing act between regulatory rigor and industry concerns. The overhaul, which reduces documentation requirements by an average of 10,000 pages per institution and allows public comment on scenarios, has drawn mixed reactions within the central bank. While supporters like Governor Michelle Bowman praised the changes as "excellent," dissenting voices like Michael Barr warned they could weaken the tests' credibility and encourage "gaming by banks". The modifications are expected to lower capital requirements by roughly 0.25 percentage points on average, easing pressure on banks to hold excess capital.

Banks, meanwhile, are cautiously optimistic about the Fed's easing path. Bank of Hawaii (BOH) executives noted that a 25-basis-point annual pickup in net interest margin (NIM) is achievable as Fed funds rates decline, with additional upside from deposit repricing. However, broader economic challenges loom, including a government shutdown that has already shaved 0.2% off real GDP growth per week and disrupted hiring by state and local governments. These factors, combined with tariffs and rising inequality, have created fertile ground for "opportunistic pricing" and sticky service-sector inflation, according to the Fed's October Beige Book.

The Fed's next moves will be closely watched for signals on its 2026 policy trajectory, particularly as leadership dynamics shift. Treasury Secretary Scott Bessent is reportedly leading the search for Powell's successor, with names like James Bullard and Christopher Waller under consideration. This uncertainty, coupled with the shutdown's economic drag, could amplify market volatility as investors weigh the risks of political interference in monetary policy and other key things to watch.

For now, the Fed's dual focus on rate cuts and liquidity support aims to stabilize markets while navigating a complex landscape of regulatory reform, data gaps, and economic fragility. As the central bank prepares to act, the coming weeks will test its ability to balance short-term stabilization with long-term resilience in an environment of unprecedented uncertainty.

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