July 1, 2022 — As the Federal Reserve (Fed) has turned ever more hawkish with each meeting there has been, appropriately, sharp focus on the accelerated pace of rate hikes. The policy-making Federal Open Market Committee (FOMC) of the Fed raised its short-term interest rate by 0.75% at the June 15, 2022 meeting and raised expectations for future hikes, further driving the debate over whether the U.S. economy will tip into recession as a result. We still expect the economy to grow, but recognize the risks, and made small adjustments to portfolios recently.
Flying a bit under radar are the FOMC’s actions to reduce the Fed’s bloated balance sheet, referred to as “Quantitative Tightening” (QT), that started in June. As previously communicated in May, the FOMC has embarked on its plan to reduce its holdings of U.S. Treasuries and mortgage-backed securities (MBS) and plans to accelerate the pace of reduction in September. There are concerns these action could adversely impact financial markets, drive interest rates higher (after an already nerve-wracking first half of 2022) and worsen the poor performance of equities.
We do not think the current path for balance sheet reduction poses a risk to markets. It has been well-communicated and is likely reflected in current market prices. However, if the FOMC were to alter the trajectory it would have an impact and the direction would depend on whether they’re accelerating or decelerating QT. Additionally, if the economy slowed more than expected and merited a slower pace by the Fed but they stuck to the current plan, markets could get roiled. At a higher level there could in principle be longer term impacts if QT slows the growth of overall money supply, which could, in turn, affect equity returns. Last, it’s worth noting while the Fed has engineered QT once before, for nearly two years from October 2017 to September 2019, the pace this projected to be 2.5-3 times as fast, with a maximum of $95 billion monthly decreases later this year compared to roughly $35 per month last time. In unchartered waters there is always a chance for a surprise.
What is QT?
So called “Quantitative Tightening” is the reverse of “Quantitative Easing” (QE). It is the unwinding of crisis-era efforts that were made to stave off financial crises and deep economic recession. The FOMC purchased $2.8 trillion of U.S. Treasuries and $1.3 trillion of MBS and agency debt during the pandemic (Figure 1) to provide liquidity to markets and to push down on longer-term interest rates. An undesirable side effect of QE, much like a decade ago, is the buildup of “excess” bank reserves shown in Figure 2 on the liabilities side of the Fed’s balance sheet. These are funds that commercial banks have in their accounts at the Fed and are the simple byproduct of the Fed’s asset purchases.
The Fed’s goal in QT is to reduce those excess reserves because they could generate future inflation. They are “excess” in the sense that commercial banks are not required to park them at the Fed. As the economy strengthens banks are more likely to loan those funds into the economy, contributing to money growth, stronger economic demand, and higher prices. As one former FOMC official put it, bank reserves are not inflationary, but are rather “kindling for inflation” at risk of being lit. While such cautionary statements never proved true in the previous cycle, there is greater risk now, with inflation already high and unemployment near record lows.
Figure 1: Federal Reserve balance sheet by selected assets ($ trillion)