Although temporary spikes in short-term borrowing rates seem to be subsiding, the Federal Reserve may announce at its October meeting that it will address liquidity shortages by growing its balance sheet again, analysts say.
The Fed has taken steps to address volatility in money markets this week, when rates for short-term borrowing spiked due to a shortage of cash.
But the central bank's latest actions fail to address structural liquidity issues facing the banking system, wrote Priya Misra, head of global rates strategy at TD Securities, in a note to clients. The banking system's reserves fell over the past two years as the Fed slimmed down its balance sheet from a peak of $4.5 trillion, and the declines are expected to continue as other liabilities, such as currency, eat into them.
The Fed will likely announce at its Oct. 29-30 meeting that it will expand its balance sheet through renewed purchases of Treasury securities, Misra wrote, adding that the purchases would help "prevent any further reserve decline."
"We have long been of the view that reserves are indeed scarce, and expect the Fed to capitulate to this view [in October]," she wrote.
The balance sheet will probably have to grow by about $10 billion per month to help prevent reserves from falling further, wrote Michael Gapen, chief U.S. economist at Barclays, who also expects the Fed to announce asset purchases in October.
Fed Chairman Jerome Powell left the door open to that scenario at his Sept. 18 news conference, saying the Fed will be "looking at this carefully" and will take up the issue at the October meeting.
"It is certainly possible that we will need to resume the organic growth of the balance sheet earlier than we thought. That's always been a possibility, and it certainly is now," Powell told reporters.

Although Powell's comments are a signal that the balance sheet may soon begin growing again, short-term money markets are "likely to remain volatile" in the meantime and to require more action from the New York Fed, Bank of America Merrill Lynch analysts wrote in a research note.
The New York Fed has temporarily injected reserves into the banking system, conducting about $200 billion worth of repo purchases between Sept. 17 and Sept. 19. Another round of repo purchases of up to $75 billion is scheduled for Sept. 20.
Those purchases have "brought more calm to the repo market," TD Securities' Misra wrote. But liquidity issues may begin popping up again around tax dates or company reporting dates, such as the end of the quarter, she added.
For now, the spikes in short-term rates earlier in the week appear to be easing, with rates returning to somewhat-normal levels. A day after breaching the top of its 25-basis-point target range, the Fed's benchmark federal funds rate returned to its target band on Sept. 18 — but just barely. The Secured Overnight Financing Rate also fell to 2.55% on Sept. 18 after soaring to 5.25% a day earlier.

Analysts say the jumps this week were largely due to temporary factors, such as a corporate tax payment deadline and a larger-than-usual issuance of Treasury securities that investors had to absorb.
Although those were "forces that we saw coming," the effects they had on liquidity were larger than the Fed and private sector analysts anticipated, Powell told reporters. The Fed's repo purchases "were effective in relieving funding pressures" and will continue as needed, he added.
The Fed also announced technical tweaks to two interest rates that help steer the federal funds rate toward the central bank's target: the interest rate the Fed pays to banks for excess reserves, and a related rate for a Fed overnight repurchase facility. Those are now 30 basis points lower, compared to the 25-basis-point cut to the federal funds rate the Fed announced Sept. 18.
Powell did not explicitly endorse the view of several market analysts that the banking system is experiencing a shortage of reserves, but he said officials will continue monitoring money markets and assess whether the level of bank reserves is adequate as the end of the third quarter approaches.
"I think we'll learn quite a lot in the next six weeks," Powell said.
