NEW YORK (Reuters) -The Federal Reserve's effort to shrink the size of its balance sheet is moving into a more uncertain phase as a key proxy of excess liquidity has been very nearly extinguished.

Over recent days cash flowing into the central bank's overnight reverse repo facility has fallen very close to zero, capping what has been a long and slow grind down from a peak of $2.6 trillion on the final trading day of 2022.

The facility takes in cash primarily from money market funds, which use it to park liquid assets beyond what they need. Reverse repos have been falling since the Fed in 2022 began the process of shrinking its balance sheet by allowing a set amount of Treasury and mortgage bonds to expire each month and not be replaced, a process called quantitative tightening, or QT. That's taken Fed holdings from a peak of $9 trillion in the summer of 2022 to the current level of $6.7 trillion.

The rate the Fed pays for these de facto loans is a key part of the central bank's monetary policy toolkit and helps set a floor for the central bank's interest rate target, currently in a range between 4.25% and 4.50%.

On Thursday, reverse repos stood at $32 billion, a level last seen in the spring of 2021. Some modest sum was always expected to remain in the facility, even as use shriveled as the QT process reduced liquidity in the financial system. That said, analysts do expect to see periodic usage surges, particularly around month and quarter ends when there are swings in market liquidity that can cause funding pressures.

TIME OF TESTING

Quantitative tightening is expected to go on for a while, with market participants projecting it can run until the start of next year. While reverse repos, which soaked up much of the aggressive stimulus provided by the Fed during the COVID-19 pandemic, are effectively drained out, Fed officials believe there remain large levels of liquidity left in the banking system that QT can bring down.

The effective end of reverse repo usage will test that notion, however. With Treasury borrowing issues settled after the passage of the Republican spending bill, QT will now begin to remove reserves from the banking system, which means liquidity will drain more quickly at this point.

Banking system reserves currently stand at around $3.3 trillion, about where they've been over the last couple of years. That should start to ebb but no one is sure how much they can fall before liquidity tightens too much. A dearth of liquidity would lead to volatility in short-term rates and it would compromise the Fed's control of its interest rate target.

That's how the last iteration of QT ended. In September of 2019, the Fed withdrew too much liquidity from the financial system, short-term rates went haywire and the central bank was forced to add temporary liquidity to markets to steady the financial system.

The Fed doesn't think it will play out that way again. It has a new tool called the Standing Repo Facility, which allows eligible financial firms to hand bonds to the Fed in exchange for fast cash. That tool has seen some small usage at quarter ends when liquidity is tight, and the Fed is expecting to see more of that going forward.

At the Fed's July policy meeting, the New York Fed official responsible for implementing monetary policy told members of the rate-setting Federal Open Market Committee "there would be times - such as quarter-ends, tax dates, and days associated with large settlements of Treasury securities - when reserves were likely to dip temporarily to even lower levels." Minutes from that gathering noted "at those times, utilization of the SRF would likely support the smooth functioning of money markets and the implementation of monetary policy."

The challenge for the Fed is that the SRF is untested thus far in a high demand situation, so there remains some risk it does not act as the shock absorber it is designed to be. The Fed has also provided guidance that if needed it will implement traditional repo operations to add liquidity.

It's an uncertain situation with a lot of moving parts and that means many Fed watchers are not sure how it will all play out. In a speech earlier this summer Fed Governor Christopher Waller suggested reserves could have some way to go and might ultimately rest at $2.7 trillion.

But some in markets think conditions indicate QT needs to stop soon.

"Something changed" in markets, said Scott Skyrm, of money market trading firm Curvature Securities. "Massive bill issuance dumped a lot of new Treasury supply into the market, the (reverse repo) facility is close to zero, and bank reserves are declining," while "the repo market is starting to experience more bouts of funding pressure." Skyrm reckons the Fed needs to stop QT this fall to reflect tighter monetary market conditions.