By: Bill Fain, Insurance Portfolio Manager
In the fourth quarter of 2021, with the backdrop of increasing inflation, the Federal Reserve (the “Fed”) began the process of withdrawing its monetary support for the U.S. economy. The most delicate element of the plan is likely to be shrinking its record balance sheet (currently about $9 trillion) – something that ended up roiling financial markets the last time policy makers did it.
The end of quantitative easing
The process of shrinking the Fed Balance Sheet is the opposite of quantitative easing (QE), which has been going on since the beginning of the pandemic. In QE, a central bank buys bonds to drive down longer-term rates. As it creates money for those purchases, it increases the supply of bank reserves in the financial system, and the hope is that lenders go on to pass that liquidity along as credit to companies and households, spurring growth. Quantitative tightening (QT), conversely, means reducing the supply of bank reserves.
The Fed accomplishes this by letting the bonds it has purchased reach maturity and run off its balance sheet. They created the money it used to buy the bonds out of thin air. The Treasury Department “pays” the Fed at the maturity of the bond by subtracting the sum from the cash balance it keeps on deposit with the Fed. To meet its ongoing spending obligations, the Treasury needs to replenish that cash by selling new bonds. When banks buy those bonds, they reduce their reserves, draining money from the system and undoing what was created in QE.
When will quantitative tightening begin?
The Fed is currently reducing the pace of its monthly bond purchases, which until November were running at $120 billion a month. The purchases are scheduled to end in mid-March. Last time around, the Fed kept its balance sheet steady for about three years after finishing the taper. It did that by using the money from maturing bonds to buy replacements. It didn’t turn to quantitative tightening until it had raised its interest rate target range from near zero to 1% to 1.25%. This time around, the Fed has said it will not raise rates until it is done tapering.
The Fed’s asset holdings – mostly Treasuries and mortgage bonds backed by government agencies – more than doubled during the pandemic, to about $8.8 trillion from $4.2 trillion. The total will keep rising until the taper is complete in March.
The effects of quantitative tightening
As the QT process takes money out of the financial system, some borrowing costs are bound to rise. So, just as QE drove interest rates down, QT can be expected to put pressure on them to rise. How this process plays out with respect to market liquidity and valuation remains to be seen and warrants close monitoring over the coming year.