What the Fed’s “Quantitative Tightening” Plans Mean

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Roughly two years after launching the largest and most comprehensive monetary stimulus campaign in modern history, the Federal Reserve is in the process of withdrawing its support for the US economy. Probably the most sensitive element of the plan will be the reduction of its record balance sheet, something that wound up rattling financial markets the last time politicians did it. The quantitative adjustment plan, as it is known, was published on May 4.

1. What is quantitative adjustment?

The easy answer is that it is the opposite of quantitative easing or QE. Milton Friedman had proposed a type of QE decades ago, and the Bank of Japan pioneered its use in 2001 after it ran out of conventional ammunition, cutting its short-term benchmark interest rate to zero. In QE, a central bank buys bonds to lower long-term rates as well. As it creates money for those purchases, it increases the supply of bank reserves in the financial system, and the hope is that lenders will pass that liquidity along as credit to businesses and households, spurring growth. QT means reduce supply reserves.

2. How does that happen?

By the Federal Reserve letting the bonds it has bought come to maturity and deplete on its balance sheet. He effectively created the money he used to buy the bonds out of thin air. The Treasury Department then “pays” the Fed at maturity of the bond by subtracting the sum from the cash balance it holds on deposit with the Fed, making the money disappear. To meet its spending obligations, the Treasury needs to replenish that pile of cash by selling new securities. When banks buy those Treasuries, they draw down their own reserves, thereby draining money from the system and undoing what was created in QE.

3. Have central banks made this change before?

Not often. The BOJ allowed its balance sheet to shrink in 2006-07, in what many see in hindsight as a premature tightening of policy amid Japan’s continuing battle with deflationary pressures. The European Central Bank also allowed its asset holdings to fall in 2013-14 after rising during the euro crisis. The Fed first used QE in the midst of the 2008 financial crash and during the weak recovery that followed, then implemented QT once it thought the economy was strong enough. The tightening lasted just under two years, from 2017 to 2019.

4. What has the Fed decided this time?

The Fed’s asset holdings, mostly Treasuries and mortgage bonds backed by government agencies, more than doubled during the pandemic, to about $8.9 trillion from $4.2 trillion. That total stopped rising in April, after the Fed completed a “winddown” on those purchases. At the May 3-4 policy meeting, the Fed decided to reduce the balance sheet at a maximum monthly pace of $60 billion in Treasuries and $35 billion in mortgage-backed securities, after an initial few months at a slower pace. slow. The $95bn rate is nearly double the top rate of $50bn the last time the Fed cut its balance sheet from 2017 to 2019.

5. What does that mean for the economy?

As the QT process takes money out of the financial system, borrowing costs rise; just as QE lowered interest rates, QT can be expected to put pressure on them to rise. And, coupled with the expected steep trajectory of interest rate hikes by the Fed, they had already started to rise. Ten-year Treasury yields in May topped 3% for the first time since 2018. And mortgage rates soared, with 30-year fixed-rate offerings topping 5% in April to hit the highest level since 2010, which affected the demand for housing.

6. How did the markets react last time?

Quite different from what the Fed anticipated. Then-Chair Janet Yellen said in June 2017 that “this is something that will be running quietly in the background for several years” and that “it will be like watching paint dry.” While QT got off to a smooth start in October 2017, just three months later bonds slumped around the world and stocks fell, possibly in response to a combination of the Fed QT and the European Central Bank signaling it might be open to modify its own stimulus policy. In November 2018, some market participants argued that the Fed had cut bank reserves too drastically, leaving lenders scrambling for cash and roiling money markets. The dollar strengthened, putting pressure on emerging market borrowers who had accumulated dollar-denominated debt. Developing country bond premiums skyrocketed. US junk-rated corporate debt also saw spreads over the gap to wider Treasuries in late 2018.

7. What did the Federal Reserve then do?

At first, he stuck to his QT policy, with Powell, by then Yellen’s successor as chairman, at one point saying the program was on “autopilot.” But after the S&P 500 index fell nearly 16% over three weeks in December 2018, the Fed blinked. It abandoned rate hikes in January and announced the phasing out of QT in March 2019.

8. Did that calm the markets?

Not completely. In September 2019, rates rose in the repo market, a key source of short-term funding, prompting the Fed to inject short-term liquidity in its first such operation in a decade. The following month, policymakers said they would increase Treasury bill purchases to maintain an ample supply of bank reserves.

9. So, will the market be chaos again?

Former US Treasury Secretary Lawrence Summers once said that the four most dangerous words in the markets are “this time is different”. But circumstances have changed since the Fed last went through policy normalization. For one thing, the Fed’s day-to-day operating framework has been changed so that it commits to holding “ample” reserves in the system. The Fed said on May 4 that “to ensure a smooth transition,” it intends to “slow and then stop the decline in the size of the balance sheet when reserve balances are slightly above the level it considers consistent.” with wide reservations. Powell told Congress in early March that the process would take about three years, involving roughly $3 trillion or more in cuts, given the plan the Fed later unveiled.

10. Any new safety valve?

Yes, this time the Fed has new tools it can use to avoid at least some short-term stress in financial markets. Last year, it introduced the Standing Repo Facility, which can provide the banking system with up to $500 billion in cash overnight. A separate facility offers dollars to other central banks around the world. The Federal Reserve Bank of New York can also set up unscheduled domestic repurchase agreements. A sustained increase in facility use could serve as a sign of trouble ahead. But with US fiscal policy tightening in 2022 as spending to ease the pandemic slows, and with geopolitical dangers impacting, not to mention the still-lingering, hard-to-predict pandemic, there could still be other tensions that combine to affect financial markets.

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