For just the second time in modern history, the Federal Reserve started quantitative tightening in June to draw down its unprecedented $9 trillion balance sheet. The central bank’s assets on hand have more than doubled since the start of the pandemic.
“I would just stress how uncertain the effect is of shrinking the balance sheet,” Federal Reserve Chair Jerome Powell warned in May.
The hope is that tighter monetary policy will cool 4-decade high inflation. In May, consumer prices soared to an annual rate of 8.6%, the fastest pace in more than 40 years.
“We are always throwing Hail Mary passes,” economist Richard Wolff said of quantitative tightening.
Quantitative tightening, or QT, is a contractionary monetary policy where a central bank reduces the size of its balance sheet.
To understand how it works, though, we need to understand its counterpart, quantitative easing, or QE.
How we got here
Quantitative easing occurs when the Federal Reserve buys bonds on the open market to pump money into a struggling economy. That practice gives institutions like banks more liquidity, which encourages more lending, which stimulates spending.
The bonds purchased by the Fed then go onto the Fed’s balance sheet. The Fed has twice practiced significant quantitative easing efforts, in the years following the 2008 financial crash and again when COVID-19 hit.
Time to tighten
“Quantitative tightening, then, is the exact opposite,” Wolff said. “That’s when the Federal Reserve says, ‘Oh my God, there’s too much money in the economy, we think the economy needs to have less money in it.'”
In that case, the central bank has a couple of options for quantitative tightening: Resell its bonds on the open market or simply let bonds mature without replacing them. The latter is called passive tightening. That’s what the Fed started doing June 15.
“If the Fed owns a security and it matures, it means that the issuer of the security has to pay off the owner of it because it’s reached its maturity,” Wolff explained. “That money is flowing out of the private sector to the Federal Reserve…and they just don’t recirculate that money.”
QT impact on markets
The last time the Fed tried quantitative tightening was between 2017 and 2019, after years of quantitative easing following the Great Recession. At the time, the Fed’s balance sheet hovered around $4.5 trillion.
Even though the pace of runoff was incredibly slow, the stock market still spooked.
“They tried it, they got smacked in the face by what the stock market told them, and they turned around and stopped doing that,” Wolff said.
When the Federal Reserve stopped the drawdown in 2019, they had trimmed the balance sheet to about $3.8 trillion. The maximum reduction in assets had reached $50 billion per month.
This time, the Fed hopes to ramp up reductions to $95 billion per month in much faster fashion. Many economists expect officials to try to shrink the balance sheet by about $3 trillion over a 3-year span.
Quantitative tightening will happen at the same time the central bank is on a campaign to raise its benchmark interest rate, another tool to suppress demand.
With inflation reaching 8.6%, the consensus is there’s not much of a choice when it comes to tightening monetary policy, even with the S&P 500 already in a bear market. Many believe the Fed, tasked with price stability and maximum employment, must do what it can to cool entrenched inflation, even if it triggers a recession.
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