Central Bank Policies: Quantitative Tightening
Quantitative tightening (QT) pertains to monetary strategies aimed at contracting or reducing the balance sheet of the Federal Reserve System (Fed). This procedure is also recognized as balance sheet normalization. To put it differently, the Fed, or any central bank, decreases its monetary reserves by either selling Treasuries (government bonds) or allowing them to mature and subsequently removing them from its cash holdings. This action effectively drains liquidity or money from the financial markets.
This stands in stark contrast to quantitative easing (QE), a term that has become deeply ingrained in the financial market since the 2007–2008 global financial crisis. QE refers to the monetary policies enacted by the Fed to expand its balance sheet, as we covered previously.
The Fed’s primary objective is to maintain the optimal functioning of the U.S. economy. Consequently, its mandate involves implementing policies that support maximum employment while also safeguarding against inflationary pressures. Inflation signifies the economic phenomenon in which the prices of goods and services gradually increase over time. High levels of inflation can erode consumers’ purchasing power and, if left unaddressed, may have adverse effects on economic growth. The Fed is acutely aware of this and tends to take proactive measures if it detects signs of such inflationary trends.
The initial action taken by the Fed to counter excessive inflation is to raise the federal funds rate. In doing so, the central bank influences the interest rates that banks apply when lending to various customers, including both corporate and residential borrowers. For instance, this would impact mortgage rates for homebuyers. Elevating the federal funds rate results in higher mortgage rates and monthly payments, which, in turn, typically reduce demand for properties, leading to either price stabilization or a decrease.
Another approach to pushing interest rates higher is through a mechanism known as QT. As previously mentioned, this can be achieved in two primary ways: either by selling government bonds in the secondary Treasury market or by not repurchasing the bonds held by the Fed when they mature.
Both methods of implementing QT would increase the supply of bonds available in the market. The primary objective is to reduce the amount of money in circulation to counter the rising inflationary pressures. This process invariably leads to higher interest rates.
Recognizing that the bond supply would continue to grow due to additional sales or the absence of government demand, potential bond buyers would demand higher yields to purchase these securities. These elevated yields would result in increased borrowing costs for consumers, making them more cautious about taking on debt. This, in turn, should temper demand for assets (goods and services). Reduced demand generally leads to price stabilization or even decreases, serving as a check on inflation, at least in theory.
Inflation
Inflation plays a crucial role in fostering a healthy and stable economy. It becomes problematic when it accelerates to the point where it outpaces wage growth. For instance, if an individual earns $4,000 per month and allocates $500 for groceries, any increase in grocery costs while their income remains the same would reduce their ability to spend on other items or save for investments. This decrease in purchasing power effectively diminishes their overall financial well-being.
Most economists agree that an annual inflation rate of 2% to 4% in a robust economy is manageable, as it is reasonable to expect wage growth to keep pace. However, if inflation starts to accelerate significantly higher, expecting wages to match becomes unreasonable.
Transitioning from QE to QT
Transition from QE to QT, often referred to as tapering, involves gradually reducing the asset purchases made under QE. This typically involves decreasing the amount of maturing bonds repurchased by the Fed until it reaches zero, at which point further reduction constitutes QT.
The initial round of QT, often referred to as QT-I, commenced in October 2017, following the recovery of the economy from the global financial crisis. In response to the crisis, the Federal Reserve had implemented a series of significant asset purchases that led to an expansion of the Fed’s balance sheet. QT-I effectively reduced the Fed’s balance sheet, or its overall liquidity, by just under $700 billion by August 2019, marking its conclusion.
Source: St. Louis Fed
However, in September 2019, financial markets faced pressures in the money market due to a drop in bank reserves to less than $1.4 trillion, equivalent to about 7% of GDP. In response to these ensuing financial market stresses, the Federal Open Market Committee (FOMC) announced on October 11, 2019, that it would bolster reserves through the acquisition of Treasury bills via term and overnight repo operations.
This episode of market stress underscored a crucial aspect related to the Fed’s new monetary framework. Despite the presence of ample reserves, there exists a critical threshold of reserves below which financial markets can experience stress.
In May 2022, the Fed announced its decision to initiate QT alongside an increase in the federal funds rate to counter the emerging signs of accelerating inflation. The Fed’s balance sheet had expanded to nearly $9 trillion due to its QE efforts in response to the 2008 financial crisis and the COVID-19 pandemic.
Starting from June 1, 2022, the Fed would allow approximately $1 trillion worth of securities ($997.5 billion) to mature without reinvestment over a 12-month period. Fed Chairman Jerome Powell estimated that this amount would have an impact on the economy similar to a 25 basis point rate hike.
For the first three months, caps were set at $30 billion per month for Treasuries and $17.5 billion per month for mortgage-backed securities (MBS). Afterward, these caps would be increased to $60 billion and $35 billion, respectively. As the Federal Reserve proceeds with QT-II (from June 2022), it must carefully assess when to moderate and cease redemptions to prevent an excessive reduction of reserves within the banking system, which could lead to undue financial stress. Evaluating the optimal magnitude of additional QT requires a close examination of the key participants and institutions with which the Fed interacts, and their impact on reserve balances within the banking system.
At present, there are three distinct domestic Fed counterparties that influence the level of reserve balances: banks, non-banks, and the U.S. Treasury. Each of these entities operates under different market conditions, regulatory frameworks, and policy constraints, independently contributing to the distribution of system liquidity in line with the Fed’s chosen aggregate liquidity level.
Banks require reserves to fulfill internal and regulatory liquidity requirements, with these demands evolving over time as the financial system expands and regulations evolve. Understanding the needs of banks is essential to ensure that the Federal Reserve does not deplete reserves excessively during the ongoing tightening cycle.
Non-banks engage with the Federal Reserve through their overnight reverse repurchase (ON RRP) balances. Many significant non-bank institutions, such as government-sponsored enterprises and money market funds, have access to the Fed’s ON RRP facility, allowing them to deposit funds and earn the ON RRP offering rate. Including non-banks as counterparties to the Fed became necessary due to their increased significance within the financial system compared to banks. This shift resulted in a transfer of liabilities from bank reserve balances to the ON RRP facility. The utilization of this facility affects reserve balances (see below chart). The Fed’s ON RRP facility grew from nearly zero in the spring of 2021 to $2.55 trillion at the close of December 2022 (largely due to year-end effects) and stood at $2.37 trillion by the end of March 2023. Monitoring the evolution of activity at this facility is crucial, as rapid shifts in and out of it can either deplete or augment reserve balances.
Source: St. Louis Fed
The historical record shows that the Treasury Department can significantly impact the Fed’s balance sheet. In the midst of the debt ceiling impasse of 2023, the Treasury General Account (TGA) experienced a sharp decrease, plummeting from $296 billion in late April to $48 billion by the end of May. When the TGA declines, it tends to result in an increase in reserve balances. During this specific debt ceiling impasse, reserve balances surged by $173 billion, while ON RRP utilization decreased by $70 billion. Once the debt ceiling issue was resolved in June, the Treasury resumed issuing debt, and the TGA balance was restored to $432 billion by mid-August. Concurrently, reserve balances, along with ON RRP facility take-up, decreased by $86 billion and $455 billion, respectively. Money market mutual funds began investing in U.S. Treasury bills offering yields higher than the ON RRP rate, prompting non-banks’ funds to shift from the facility to Treasury bills.
Additionally, the Federal Reserve itself can take actions that impact the level of reserve balances. The banking turmoil witnessed in March 2023, marked by sudden runs on bank deposits stemming from the eventual failure of three relatively large U.S. commercial banks, led the Fed to establish the Bank Term Funding Program. This program, coupled with the Discount Window, triggered a temporary increase in bank reserves and overall liquidity, as the Fed’s balance sheet experienced a temporary expansion. These measures were viewed as efforts to reinforce financial stability during a period of contagion. As the banking turmoil subsided and the use of liquidity facilities stabilized at lower levels, the pace of reductions in total assets, associated with QT, resumed its prior trajectory.
As of mid-August 2023, the Federal Reserve’s balance sheet stood at $8.19 trillion (equivalent to approximately 30% of GDP), bank reserve balances totaled $3.22 trillion (around 12% of GDP), and ON RRP facility take-up amounted to $1.79 trillion (about 7% of GDP). As QT-II continues at an accelerated pace, the Federal Reserve is likely to re-evaluate the ideal level of reserves in the near future. In the May 2023 Senior Financial Officer Survey, 78% of respondents indicated that their banks prefer to maintain additional reserves beyond their lowest comfortable level of reserves (LCLOR), with 35% preferring to hold additional reserves equivalent to at least 50% above their LCLOR. Furthermore, approximately three-quarters of respondents reported that their banks do not permit reserves to fall below their LCLOR.
Earlier this year, Governor Christopher Waller suggested that ON RRP balances could decrease to zero without adversely affecting market liquidity. If this scenario holds true, the Fed could continue QT for an extended period without excessively depleting reserves. However, there is a risk that ON RRP balances remain substantial, and bank reserves constitute the primary portion of the contraction in Fed liabilities during QT’s progression. In such a scenario, regulatory constraints on banks may start binding earlier than anticipated. Since late March 2023, ON RRP take-up has diminished by $576 billion; nevertheless, the planned issuance of Treasury bills alone may not be adequate to completely deplete the facility in the latter half of 2023.
Risks of QT
It is worth mentioning that QT presents a risk of potentially destabilizing financial markets, as briefly seen in the U.S. regional banking system, and worst case potentially leading to a global economic crisis. No one, including the Fed, desires a significant sell-off in stock and bond markets due to widespread panic resulting from a lack of liquidity. This kind of event, known as a “taper tantrum,” occurred in 2013 when then-Fed Chairman Ben Bernanke merely mentioned the possibility of tapering asset purchases. We will see how this ends in the coming years.
Written by: Gunter Lackmann
