Fed Balance Sheet Contraction Details and Quantitative Tightening

Quantitative tightening… Quantitative tightening (QT) is a contractionary monetary policy, which is the opposite of QE. Government bonds and other assets purchased from the market by central banks through QE programs are kept on their balance sheets, greatly increasing their size. In 2018, the Fed began to amortize some of the debt on its balance sheets, starting with quantitative tightening. In 2019, less than a year after launching QT, central banks, including the Fed, discontinued quantitative tightening due to adverse market conditions that soon followed.

Starting June 1, the Fed began shrinking its $9 trillion balance sheet to mobilize liquidity. At the May FOMC meeting, where it was announced that QT would start on June 1, the Fed raised the target rate to 0.75-1.00%. The central bank has purchased roughly $4.6 trillion of Treasury and mortgage-backed securities through quantitative easing over the past two years to maintain longer-term interest rates. The process, also known as QE, led to an increase in bank reserves.

Fed balance sheet size and federal funding rate comparison… Source: Bloomberg, Federal Reserve

Downsizing of the balance sheet… Of the $4.6 trillion in assets in the money market, $4 trillion is invested in funds that are only allowed to invest in high-quality, short-term assets such as Treasury bills or repurchase agreements. These balances have grown during the pandemic as a result of stimulus from the Fed and the US Treasury. QE has left banks holding more cash than they wanted, so it continues to encourage depositors to invest cash in money market funds instead.

The growth in cash flow coincided with a contraction in the pool of assets money market funds could invest in. The Treasury has been cutting off the bond supply since the end of 2020. As the Fed’s QE continues to add cash to the financial system, the drama of Washington’s debt ceiling at the end of 2021 and now unexpectedly strong tax revenues has left market participants in fierce competition for assets.

QT, reserves and balance sheet assets… As the Fed plans to roll over some of the bonds on its balance sheet at maturity without exchanging them for other assets, QT will reduce the supply of reserves. If the amount of coupon debt due is less than this, it can fill the gap by not changing some of its bonds. The government would then “pay” the bond due by subtracting the sum from the cash balance the Treasury deposited with the Fed, thereby effectively eliminating the money.

To meet its spending obligations, the Treasury needs to replenish its cash pile by selling new debt. Normally, banks reduce their own reserves when they buy these securities, thereby withdrawing money from the system and removing the effect of QE.

Conclusion? With QT, the Central bank sells the balance sheet assets, basically all the bonds currently on their balance sheet, reducing the money supply circulating in the economy. The tightening before that took a little less than two years, from 2017 to 2019. After 2020, the Fed’s assets—mostly Treasuries and mortgage bonds—more than doubled during the pandemic, from $4.2 trillion to nearly $8.9 trillion.

The Fed can also change the money supply by changing short-term interest rates. By lowering (or raising) the discount rate banks pay for short-term loans from the Fed, the Fed can effectively increase (or decrease) the liquidity of money. With bank reserves of approximately $3.3 trillion, we are far from liquidity shortages for now

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