Quantitative tightening

July 27, 2023
10 MIN READ
51 VIEWS
The contraction or reduction of the Federal Reserve System's (Fed's) balance sheet is known as quantitative tightening (QT). The term "balance sheet normalization" describes this procedure. By selling Treasurys (government bonds) or allowing them to expire and be removed from cash balances, the Fed (or any central bank) reduces its monetary reserves. The result is less money and hence less liquidity in the financial markets. It is the antithesis of quantitative easing (QE). The phrase has entered everyday use in the financial markets ever since the 2008 financial crisis and refers to the Federal Reserve's decision to increase the size of its balance sheet.

What is quantitative tightening?

The Federal Reserve and other central banks' primary responsibility is maintaining a healthy economy by promoting full employment and price stability. It is accomplished via the Federal Open Market Committee's management of the Fed Funds Rate. In practice, this affects the interest rates banks charge businesses and individuals for various types of lending. However, when interest rates are already at historically low levels, and the economy still needs support, the Fed has to resort to other measures. Quantitative easing involves the government increasing its holdings of Treasury bonds, mortgage-backed securities, and even equities, while quantitative tightening reduces these holdings and hence the money supply. Both have significant impacts on market liquidity. When the worldwide Financial Crisis of 2007–2008 was over, the Federal Reserve stepped in with billions of dollars in quantitative easing; the same happened during the worldwide Coronavirus outbreak. However, the Federal Reserve cannot continue creating money indefinitely. The Federal Reserve (Fed) must resort to quantitative tightening whenever it uses quantitative easing to mitigate the inflationary effects of the former.

The concept of quantitative tightening (QT)

The Fed's principal mission is to keep the United States economy running smoothly. Therefore, it is tasked with enacting policies encouraging maximum employment while preventing inflation. The term "inflation" describes steadily increasing prices throughout the economy. Inflation may slow economic development if it is allowed to persist at high levels and reduces consumers' purchasing power. The Fed is well aware of this and typically takes prompt action in response to proof that it is occurring.

The Federal Reserve raises the federal funds rate as its first defense against out-of-control inflation. The Federal Reserve Board (Fed) controls commercial interest rates, and savings banks charge their business and individual borrowers. Mortgage interest rates are an illustration of home financing. Raising the federal funds rate would increase mortgage rates and monthly payments, reducing demand for real estate and likely resulting in lower prices or price stability.

Quantitative tightening (QT) is another tool central banks may use to push up interest rates. In addition to not repurchasing maturing Fed-held bonds, selling government bonds outright on the secondary Treasury market is another option. There would be more bonds on the market with any QT implementation strategy. The primary emphasis is lowering the money supply to rein in the spiraling inflationary pressures. The method used always leads to increased interest rates.

Potential bond purchasers would need higher yields to acquire these offerings if they knew that supply would continue to expand due to more sales or the absence of government demand. Consumers would be more wary of taking on debt if interest rates were to rise due to these higher returns. Ideally, this will reduce the need for assets (i.e., products and services). In principle, less demand results in price stability or reductions and a curb on inflation.

Is inflation a negative factor?

A noteworthy aspect of inflation: Inflation is essential to developing a robust economy. When it begins to rise faster than wages, we have a problem. If one earns $400 per month and sets aside $50 for food, and the cost of groceries increases, but one's income remains the same, that person's spending and savings will be reduced. Their disposable income has shrunk, making them economically "poorer."

In a robust economy, most economists agree that an annual inflation rate of 2% to 4% is tolerable, given that wage growth expectations are fair. If inflation suddenly skyrockets, however, salary increases will be unrealistic.

Wage-price spiral and inflation

Nevertheless, runaway inflation is readily triggered when employees demand higher salaries in response to rising inflation expectations. Businesses then pass this cost on to customers through increased prices, reducing their buying power.

QE, or large-scale asset purchases (often a mix of government bonds, corporate bonds, and even stock acquisitions), are a contemporary monetary policy instrument used to boost the economy and help it recover from a prolonged recession. However, QE carries with it the genuine danger of inflation. Overstimulation may lead to inflation, which might call for quantitative tightening to counteract the unintended consequences (rising inflation) of QE.

Comparing quantitative tightening and tapering

In reality, "tapering" refers to the period between quantitative easing and quantitative tightening, during which large-scale asset purchases are gradually reduced until they are stopped altogether. During QE, the revenues from maturing bonds are often invested in new bonds, thus stimulating the economy. However, tapering is the process through which reinvestments are reduced and halted.

The word "tapering" indicates the gradual reduction in the pace at which central banks buy assets. It is not a "tightening" of monetary policy.

Why is quantitative tightening critical?

Investors worry that quantitative tightening will have a devastating effect on the market. Over the last decade, there has been a strong connection between central bank purchases and asset returns. The steep sell-off in risk assets in December sent the S&P 500 about 20% lower than its high, and the Fed's balance sheet run-off has lately been identified as a contributing cause. Investors are understandably worried, taking these two issues into account.

The impact of quantitative tightening

Even though quantitative tightening contradicts the growth-inducing goals of quantitative easing, many Federal Reserve Governors believe it has little to no influence on the economy. Therefore, it should not be considered a structural constraint on asset returns. The following four key arguments are provided in support of the position:

     i. QT will be far less than QE.

The Fed's balance sheet will remain above its pre-crisis levels and will not decline. The top balance sheet size in 2017 was $4.5trn, up from $900bn before the crisis. In our opinion, QT will only be able to trim the balance sheet by roughly USD 3.5trn. Given the relatively modest decrease relative to the massive expansion that came before it, the immediate effect of QT is anticipated to be far less than that of QE.

     ii. QT is unlikely to reverse QE's influence on long-term interest rates entirely.

The Federal Reserve argued that quantitative easing, which included the purchase of long-term bonds and mortgage-backed securities, would lead to reduced corporate borrowing rates and a subsequent increase in the productive use of capital by stimulating the market for bonds issued by firms. Although some academic studies have challenged the effect size, the Fed's data estimates that QE cut rates on 10-year US Treasuries by 100 basis points (bps) at its highest impact.

QT is projected to mitigate some of this effect, while it is not anticipated to increase long-term rates by 100 basis points. As was said above, the balance sheet contraction will be far less pronounced than the growth it followed. There seems to be no consistent trend toward a more significant term premium. The term premium declined in the fourth quarter of 2018 when investors looked most worried that QT was affecting the risk assets negatively.

     iii. QT is unlikely to have a significant effect on either liquidity or inflation.

There will probably not be much of an effect on liquidity or inflation from QT. Liquidity and inflation might shift when there is a disparity between the available cash and the amount needed.

As a result of the increased demand for liquid assets during the financial crisis, central banks "printed money" to alleviate the situation. More than a decade after the financial crisis, the desire for liquidity diminished, prompting the Federal Reserve to reduce the cash stockpile. This reaction is expected to not affect liquidity or inflation because of the importance of maintaining a stable cash supply and demand. The inflation data over the last decade shows that QE has not caused inflation; therefore, it stands to reason that QT will not have a deflationary impact either. Inflation might become a significant issue if the Fed does not take action to reduce liquidity supplies today.

     iv. Regrowth of the Fed's balance sheet is expected.

Quantitative tightening by the Fed did not begin until October 2017, yet we may already be nearing the end of QT. The final size of the Fed's balance sheet and the exact schedule for normalization remains unknown. With an estimated USD 1trn of surplus reserves as of March 2020, the Fed may decide to speed up the timing of the completion of the balance sheet run-off.

Quantitative Tightening in 2022

To combat the early warning indications of rising inflationary pressures, the Fed said on May 4, 2022, that it would begin QT and boost the federal funds rate. As a result of QE initiatives implemented in response to the economic meltdown of 2008 and the COVID-19 epidemic, the Fed's balance sheet grew to about $9 trillion.

Important details included the Federal Reserve's decision to stop reinvesting $997.4 billion in maturing assets as of June 1, 2022. According to Federal Reserve Chair Jerome (Jay) Powell, this was about the same as the one-rate rise of 25 basis points in terms of its economic impact. For the first three months, the limits were $30 billion monthly for Treasurys and $17.5 billion monthly for MBS. The current limitations of $60 billion and $35 billion will be increased.

Disadvantages of quantitative tightening

To successfully implement QT, a fine balance must be found between draining the economy of liquidity and causing financial markets to collapse. A too-rapid removal of liquidity by central banks may shock financial markets, leading to wild swings in bond or stock prices. For instance, in 2013, a large surge in treasury rates caused bond prices to fall after Federal Reserve Chairman Ben Bernanke indicated the prospect of decreasing asset purchases in the future.

A 'taper tantrum,' as this behavior is nicknamed, is possible even during the QT interval. Another issue is that QT has never been fully implemented. After the Global Financial Crisis, QE was used to mitigate the severe economic downturn. As a result of Bernanke's remarks, the Fed delayed the start of QT until 2018 and instead implemented a third wave of QE. The Fed ended QT less than a year later because of poor market circumstances. Since this is the sole precedent, it is reasonable to assume that further adoption of QT would likely worsen current market circumstances.

Is the Fed's shift to quantitative tightening justified?

The worldwide Coronavirus epidemic and its aftermath drove up labor costs in 2022, as Russia's invasion of Ukraine impacted oil prices and commodities, contributing to the highest inflation rate in decades. Due to pandemic concerns, the Fed Funds rate was reduced to 0%-0.25% in March 2020. Rate rises continued through the summer and autumn of 2022, commencing with a 0.5% increase in May.

When will quantitative tightening begin?

As part of its "phased approach" to quantitative tightening, the Federal Reserve stated in the spring of 2022 that it would begin unwinding $30 billion in Treasuries and $17.5 billion in mortgage-backed securities over three months. These thresholds will be elevated to $60 billion and $35 billion by September 2022.

Conclusion

When the Federal Reserve (Fed) implements monetary policies that lower the size of its balance sheet, this is known as quantitative tightening (QT) or balance sheet normalization. Quantitative tightening (QT) is the antithesis of quantitative easing (QE). The Federal Reserve uses QT by selling or allowing maturing Treasurys (government bonds) to reduce its cash holdings. QT has the danger of destabilizing financial markets, which might lead to an international economic disaster.