Is the End Well-Nigh for Quantitative Tightening?

By: Simona M Mocuta, Todd N Bean, CFA, Jay L Ladieu

During the pandemic, the Fed resumed its quantitative easing (QE) program. As economic conditions normalized, it turned to quantitative tightening (QT) in the summer of 2022. What are the implications of the upcoming winding down—or tapering—of QT?

Having peaked at US$9.0 trillion in April 2022, the US Fed’s balance sheet stood at US$7.8 trillion last December. This is still double the level that prevailed in the summer of 2019, suggesting there is a long way to go before the balance sheet normalizes. Why then is the Fed considering slowing the pace of run-offs? We outline the rationale and investment implications below.

There are two key elements to the balance sheet policy discussion:

  1. The desired end point of QT
  2. The desired path – speed of QT and final balance sheet composition

The Desired End Point of QT

Multiple indicators suggest there remains excess liquidity in the financial system. For one, the reverse repo facility still holds about US$600 billion – a normal state would see that balance back to zero. Secondly, bank reserves as a share of nominal GDP remain at healthy levels even though they have moderated noticeably from the pandemic-era records (Figure 1).

Fed's balance sheet and financial liquidity measures

At the same time, while the Fed’s intent is to eliminate excess reserves, the desire is to maintain an ample reserves environment. There are no clear-cut estimates for what that level actually is, but—just as Chair Jerome Powell stated about the neutral policy rate—it, too, can be known “by its works.”

While an unusual confluence of factors resulted in the acute stress episode experienced in the repo market in 2019, one interpretation is that by that point reserves likely had become scarce. In the summer of 2019, bank reserves had fallen to below 7% of nominal GDP. All else being equal, one could argue that a cushion of 1-2 percentage points may therefore identify the lower estimate of an ample reserve environment (Figure 2).

SOFR as an indicator of stress

Some Important Differences Compared With 2019

There are some important differences between where the economy stands today versus where it was back in 2019. For one, following the aggressive monetary tightening cycle, US banks today sit on massive unrealized losses linked to their fixed income portfolios. A more conservative balance sheet management and an increased preference for reserves may be the net result (Figure 3).

US Banks sit on massive unrealized losses

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Originally Posted January 31, 2024 – Is the End Well-Nigh for Quantitative Tightening?

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