stages of quantitative tightening | Looking for Alpha

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By Thomas L. Hogan

In light of recent high inflation, the Federal Reserve has accelerated its plans to tighten monetary policy. Many journalists are reporting that in addition to raising its short-term interest rate targets, the Fed is set to end its expansionary quantitative easing (QE) program in favor of restrictive tightening action. quantitative (QT).

Some articles describe QT as the Fed “actively selling its bond holdings” or state that QT will begin “on the heels of the central bank’s first interest rate hikes,” presumably at its next meeting in March. However, QT is likely to unfold in four phases, only the last of which involves the active sale of bonds, and which may not begin for a year or more.

1. The end of QE

The Fed has been making QE asset purchases since March 2020. It currently buys $20 billion per month in US Treasuries and $10 billion per month in mortgage-backed securities (MBS). Before it can adopt a QT policy, the Fed will have to end the expansion of its QE balance sheet.

For nearly a year, the Fed has been discussing the possibility of slowing the pace of its monthly asset purchases. It only recently started doing so in November 2021. This reduction was supposed to continue until the summer of 2022, but this plan was accelerated when recent inflation turned out to be higher than expected by the Federal Open. Market Committee (FOMC).

The minutes of the last FOMC meeting show that there was talk of ending the asset purchase program after the previous meeting. However, the members ultimately decided to stick with their QE continuation plan until their next meeting, scheduled for March 15.and at 16and.

2. Stable balance sheet

Once QE is completed, the QT process may not begin immediately. Instead, the Fed is likely to maintain a constant level of total assets for some time.

During this period, any proceeds from maturing bonds will be reinvested in bonds of the same duration to keep the dollar amount and maturity distribution of bond holdings roughly constant, although Fed officials have indicated that they could adjust the asset type mix by investing the proceeds of MBS maturity in Treasury bills.

3. Passive clamping

After a period of maintaining a stable size, the Fed should begin to reduce its balance sheet passively by allowing some of the bonds it holds to mature without replacing them. The cash it receives as proceeds from these bonds will cancel out some of the cash reserves the Fed owes commercial banks, reducing the assets and liabilities on its balance sheet by an equal amount.

The Fed had previously carried out passive tightening before the COVID-19 pandemic. Its total assets were relatively flat from 2015 through early 2018, then declined through 2019 as the Fed allowed some assets to expire. During this period, the balance sheet has shrunk from $4.5 trillion to around $3.76 trillion, a reduction of 16.7% from its peak size. More than half of that reduction happened in 2018 alone, and this time around Fed officials expect an even faster pace.

Passive tightening appears to be the primary tool through which the Fed plans to drive QT. Following the January meeting, the FOMC issued a new statement, “Principles for Reducing the Size of the Federal Reserve’s Balance Sheet,” stating that the committee “intends to reduce the holdings of Reserve securities federally over time in a predictable manner”. primarily by adjusting the reinvested amounts of principal payments received from securities(emphasis added).

That said, the QT start schedule has not been set and it may be several months before such a program begins. According to the latest FOMC meeting minutes, “a number of participants said conditions would likely warrant beginning to reduce the size of the balance sheet. later this year.” (emphasis added)

4. Active clamping

Eventually, the Fed could begin the process of active tightening by selling assets from its balance sheet. This approach would reduce the balance faster than the passive QT.

Even without active QT, however, the pace of balance sheet reduction with passive QT will likely be faster than it was in 2018-19. The average maturity of assets held by the Fed is shorter than before the pandemic, so passive tightening could be used to shrink the balance sheet faster than before, potentially rendering active tightening unnecessary.

Active tightening has never been conducted on a large scale to reduce the size of the Fed’s balance sheet. It was not used to reverse the Fed’s balance sheet expansions from 2008 to 2014. Given the FOMC comments discussed above, it seems that if the active QT is to be used, it might not happen until the end of 2022 or later.

There are still several steps to take before the Fed starts selling assets to reduce the size of its balance sheet. This kind of active tightening probably won’t start for some time.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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