The Federal Reserve will release its monetary policy decision on Wednesday, and investors will be listening to what it says about possible rate cuts. They should be paying as much attention—if not more—to what it says about quantitative tightening.
When it comes to rate cuts, investors shouldn’t expect much. The Fed is expected to hold its policy rate steady in the coming meeting, with the
CME
FedWatch tool putting the chances of a hold at 97%. What Chairman Jerome Powell says about a possible March cut will matter, but so will what the Fed says about quantitative tightening, or QT for short, as it manages its balance sheet—another tool in its battle to tame inflation.
Quantitative tightening has been going on for a while. The Federal Reserve has withdrawn billions of dollars from the financial system since June 2022, but now it’s thinking of slowing the pace of QT. In the December meeting, several officials saw it “appropriate” to begin discussing slowing this rundown. The meeting on Jan. 30-31 may offer more details on the timeline for the reduction, and for good reason. The Fed is trying to avoid a repeat of what happened in 2019, when the end of QT created turmoil in the bond market that spread throughout the financial system.
Here’s everything you need to know.
What is quantitative tightening?
The Fed’s balance sheet consists of assets such as Treasuries and mortgage-backed securities. When the central bank buys more assets, it transfers money into the selling bank’s account at the Fed thereby adding liquidity to bank reserves. More money boosts the economy, increases bank lending, and lowers interest rates. This action known as ‘quantitative easing’ (QE) was employed during the 2008 crisis, and then again during the Covid-19 pandemic. The Fed’s balance sheet eventually ballooned to nearly $9 trillion.
Now, the Fed is reversing its bond buying and shrinking its balance sheet. But instead of selling the assets, it’s chosen to let as much as $95 billion worth of debt mature every month without reinvesting the cash. If the Fed isn’t keeping the assets on its balance sheet, it’s in effect reducing its balance sheet. Quantitative tightening had been tried as recently as 2017, when it didn’t end well. More on that later.
Why should investors care?
All this seems academic, but it shouldn’t. Economists at the Fed in a 2022 study estimated that reducing assets by about $2.5 trillion over years is equivalent to raising the policy rate by over half a percentage point. So far, the Fed has cut about $1.3 trillion in assets, as of Jan. 24. Any higher rates due to QT come on top of the tightening that already happened due to the 5.25 percentage points of interest-rate increases since March 2022.
Quantitative tightening has also contributed to the rise in long-term yields, Fed Chair Jerome Powell noted on Nov. 1. Though it’s hard to quantify QT’s exact contribution, higher yields shrink the value of investor portfolios, drive up housing costs, and make lending standards tighter.
What else does it impact?
The Fed’s QT has also led to more government debt going to private investors such as banks, hedge funds, broker-dealers and money-market funds as the central bank has backed away from holding public debt. The process threatens to deplete the amount of cash reserves banks hold at the Fed. If those reserves fall low enough, it could disrupt funding markets.
So far, though, that hasn’t been a problem. Bank reserves sit at $3.49 trillion, up 16% from last year. It’s possible that last spring’s banking crisis resulted in banks deciding to hold more reserves at the Fed, William English, a Yale professor and former Fed official, says.
Banks may also be responding to a proposal from Fed Vice Chair Michael Barr that would raise capital requirements and they are probably concerned, says Barry Knapp, founder of Ironsides Macroeconomics. Taken together, they point to banks positioning themselves defensively.
When will QT end?
Fed communications this month point to a slowdown, though the timeline is unclear. Wall Street is making guesses:
Citi
and
Morgan Stanley
both expect the slowdown to begin in June, though Citi expects it to finish at the end of December, while Morgan Stanley sees it completed in early 2025, according to notes this month.
J.P. Morgan
thinks the runoff will slow by April and QT will conclude at the end of November.
Before the slowdown, the Fed is likely to announce a framework and communicate plans to do the market. The central bank’s ability to choose the right moment to slow and stop is paramount—this week’s conference can provide more helpful guesses.
Why does the Fed need to get it right?
The last time balance sheet reduction took place was between October 2017 and August 2019—and it ended up gumming up the financial machinery. Cash got sucked out of banks after a swath of corporates rushed to make their quarterly tax payments before the deadline on Sept. 16, 2019. That same day, the Treasury Department was also scheduled to settle debt—or in other words, turn another chunk of cash into securities. The result? Aggregate bank reserves in September 2019 dropped to a multiyear low, falling under $1.4 trillion, or 7% of gross domestic product. The cost of borrowing for institutions reached a record high. The Fed stepped in to add more liquidity. That result suggested that the Fed may have removed more cash than was needed.
“Let’s be clear the 2019 repo blowup was the making of the Feds because they had withdrawn a lot of excess liquidity from the system, not knowing exactly where the natural stopping point would be,” said Mark Cabana, head of U.S. Rates Strategy at BofA Securities.
Is the Fed paying attention?
It is. Powell referenced the 2019 debacle on June 21, 2023, in a testimony before Congress: Suddenly reserves were scarce, and “we didn’t see it coming,” he said. But the Fed now aims for a balance sheet “where we have ample reserves, plus a buffer,” he added.
The decision on QT this time around appears hinged on the so-called overnight reverse repo facility (RRP), a place where money-market funds and others park excess cash to earn short-term interest from the Fed—a good gauge of excess liquidity in the U.S. Presently at $571 billion, it is down sharply from its peak of $2.6 trillion about a year ago.
Wall Street strategists and economists say institutions are exiting RRP due to more attractive rates being offered on Treasury bills; a short-term 4-week government debt recently offered 5.390% in annualized investment rate, while RRP offered 5.30%.
But “once the RRP facility is drained, then you move into the [bank] reserve world. And then the concern is exactly the 2019 issue,” said Citi’s economist Robert Sockin.
Will the Fed get it right?
The short but sharp disruption to funding markets in 2019 offers an important consideration for the Fed: There is no easy way to draw a line at the bank reserve level that can cause stress in financial markets.
“There’s a lot of uncertainty about where that level of reserves that [the Fed] refers to as ample is,” said
Deutsche Bank’s
U.S. head of rates research, Matthew Raskin. “Nobody really knows where it is.”
It’s just one more monetary policy uncertainty investors will have to deal with.
Write to Karishma Vanjani at [email protected]
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