The Risk of Quantitative Tightening

This past December, after a 7% year-over-year inflation increase, Federal Reserve Chairman Jerome Powell reversed course. He declared that inflation was not transitory and laid out his plan for how the Fed would start fighting it.

The first salvo would be to stop buying bonds after March 2022. The Fed has been buying $120 billion a month in bonds due to the pandemic—$80 billion in Treasuries and $40 billion in mortgage-backed securities (MBS).

Raising the Fed Funds Rate

The Fed will also begin raising the Fed funds rate, the rate at which banks borrow reserves from other banks. The Fed is trying to slow down the economy and hoping this will tamp down inflation by changing the interest rate at which commercial banks borrow reserves.

Reserves are monies that commercial banks use to pay other banks. For example, let’s say I bank at Citi and that my mechanic banks at Wells Fargo. I write him a check for $1,500. He deposits it into his checking account at Wells, and Wells increases his account by $1,500. Wells then requests $1,500 in reserves from Citi, after which my Citi checking account balance is reduced by $1,500.

Much of the time, reserves need not be moved as banks net out transactions from other banks. So, money comes into Citi, goes out of Citi, and gets netted out at the end of the day. But there are days when more money leaves a bank than comes in, and when the bank is low on reserves, it must borrow them from other banks.

The thinking is that if it costs banks more to borrow reserves, then the banks will charge borrowers more for loans.

Reducing the Balance Sheet

The Fed owns about $6 trillion in U.S. Treasury bonds, notes, and bills as well as $2.6 trillion in MBS. Altogether, the Fed’s balance sheet is around $8.8 trillion. Before the 2008 financial crisis, the Fed’s balance sheet was a little less than a trillion dollars. 

So instead of buying bonds from investors and speculators, the Fed will soon start taking money out of the economy by reducing their $8.8 trillion-dollar balance sheet.  

Suppose this is like 2017 and 2018—the last time the Fed reduced their balance sheet. In that case, the Fed allowed maturing government bonds to roll off their balance sheet, reducing the government’s account at the Fed by the amount of the maturing bond.

Let us assume all $6 trillion in treasuries the Fed owns matured on the same day. The Fed would reduce the government’s checking account by $6 trillion. Depending on how much was already there, the government might have a positive or negative balance.

Not all these bonds come due on the same day, but when individual bonds mature, they reduce the government account balance at the Fed by the bond amount. Suppose government spending remains the same or goes up. In that case, they will need to replace their depleted balance by raising taxes or, more likely, selling new bonds to the public.

The good news is that the Federal Reserve reduces its treasury holdings; in this way, it does not impact the money supply in the economy. It just changes who owns the government’s debt. But unfortunately, the same cannot be said for reducing their holding of MBS.

Mortgage-Backed Securities

Reducing holdings of MBS is more complicated. For example, last time (2017–2018), the Fed reduced their MBS holdings by not reinvesting mortgage and interest payments made by homeowners making up the MBSs.

Remember, MBS are bonds made up of mortgages. When homeowners pay their monthly mortgage, that money goes to the Fed. The Fed then reduces its balance sheet by the payment amount.

The mortgage payer sees their checking account drop by the payment amount. The mortgage payee’s bank also sees their reserve balance drop by the same amount at the Fed, who reduces the bond’s value by that same amount.

Assume all $2.6 trillion in mortgages owed by the Fed got paid on the same day. That would reduce the total deposits in the banking system by that amount. That would be about 14% of the total $19 trillion of U.S. bank deposits. Any considerable reduction in an economy’s money supply can have dramatic impacts.

How Did the Fed Do Last Time They Reduced Their Balance Sheet?

Starting in October of 2017, the Federal Reserve began gradually reducing its balance sheet, reversing quantitative easing in a process called quantitative tightening (QT). They did it by letting maturing treasuries roll off and not reinvesting mortgage payments into new MBS. 

They began QT with a balance sheet of $4,460 trillion. They reduced it for roughly two years, then ended it early, having reduced it by approximately $700 billion or 15%.

Within that period (4th Quarter of 2018), the Dow Jones fell by 16%, the S&P by 18%, and the NASDAQ by 22%.

Famed hedge fund manager Stanley Druckenmiller and former Fed Governor Kevin Warsh wrote an op-ed that said reducing the balance sheet jeopardized the economy.

In 2017 and 2018, the Fed started reducing its balance sheet for procedural reasons. They did not like having such a big balance sheet that distorts the markets. The inflation rate was 2.1% in 2017 and 1.9% in 2018. Today, that rate is 7%, some caused by the Fed, so they might not have the luxury of stopping QT this time.

Tim Hayes’s opinions and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted on as individualized investment advice.

Scroll to Top