(Bloomberg) -- The US Federal Reserve has begun the process of phasing out its effort to remove trillions of dollars of excess cash from the financial system – a leftover of its injection of emergency economic support during the pandemic. The effort, known as quantitative tightening, has been under way for two years, and officials want to make sure to stop it before they cause the kind of financial disruptions caused by the last round of QT, in 2017-2019. There’s no specific timeline yet, however, and market participants disagree on how much longer QT can last without causing more disturbances.
1. What’s quantitative tightening?
The easy answer is that it’s the opposite of quantitative easing, or QE. With QE, a central bank typically buys bonds, which helps to drive down longer-term interest rates — complementing the cuts to the policy rate, which is usually an overnight benchmark. A central bank essentially creates money out of thin air to do that, with the purchases having the effect of increasing the supply of bank reserves in the financial system. That extra boost of reserves, in theory, supports banks’ appetite to keep extending credit, which aids the economy. When a central bank shifts to QT, it begins withdrawing that extra cash from bond markets.
2. How does that work?
In the Fed’s case, it’s allowing a chunk of the bonds it purchased to reach maturity without replacing them. That process, over time, has the effect of removing liquidity from the financial system that QE had injected. It happens in a series of operations. When a bond the Fed holds hits maturity, the Treasury Department “pays” the Fed by subtracting the requisite amount from the cash balance it keeps on deposit with the Fed. In order to replenish its cash — which is vital, because that’s what the Treasury uses to pay the government’s obligations — the Treasury needs to sell new securities. As private-sector buyers purchase those new Treasuries, the process drains cash from the financial system, undoing the money creation of QE.
3. What’s the scope of the Fed’s current QT?
The Fed has been shrinking its asset holdings — mostly Treasuries and mortgage bonds backed by government agencies — since June 2022. As of May, the Fed was doing so at a pace that allowed a maximum of $60 billion in Treasuries and $35 billion in mortgage-backed securities to mature every month without replacement. That $95 billion a month is nearly double the peak rate of $50 billion the last time the Fed trimmed its balance sheet, ending in 2019. Starting in June, the Fed will reduce the Treasuries cap to $25 billion. QT has helped take the Fed’s balance sheet down by about $1.6 trillion as of May, from a record peak of near $9 trillion reached in early 2022. The balance sheet more than doubled after Covid-19 struck and the Fed moved to snap up trillions of dollars’ worth of securities.
4. Why did the Fed slow QT? Was there a problem?
So far, QT hasn’t set off the kinds of problems seen in 2019, when the Fed ended up draining so much liquidity that it caused a near freeze-up in an important area of the money markets. Indeed, precisely to avoid a repeat of that mistake, policymakers said on May 1 that they would dial back the pace of QT. That’s after bouts of volatility were seen in money markets at the end of November and into December that pushed up one benchmark — the Secured Overnight Financing Rate — to new all-time highs.
5. What’s the worst that can happen?
The previous QT experience offers a hint. The first sign of trouble came in December 2018, when — during a time of year when demand for cash was seasonally high — a declaration by Fed Chair Jerome Powell that QT would keep going on “automatic pilot” contributed to a 7% tumble in the stock market in a week. The next month, the Fed abandoned plans for a rate hike, and in March 2019, it announced the phasing out of QT. Despite that, by September 2019, borrowing costs spiked in an essential part of the economy’s financial plumbing — the so-called repo market, where banks, money-market funds and others lend capital for short periods. That suggested there were insufficient bank reserves in the system — in other words, the Fed had taken out too much liquidity. Policymakers injected funds and then embarked on what some dubbed a “QE lite” program, snapping up Treasury bills.
6. How do policymakers think about things now?
Powell last year highlighted the Fed’s determination to avoid the kind of disruption that happened with QT last time, and the central bank has decided to stop at a point when there’s still an “ample” level of reserves in the financial system. As of the policy meeting that ended on March 20, policymakers viewed the level of reserves as “abundant,” according to minutes of that gathering. They also assessed that the QT process was “proceeding smoothly.” But, in light of how they were taken by surprise the last time around, officials “broadly assessed it would be appropriate to take a cautious approach” going forward. Slowing the pace of QT would help the Fed make the transition from “abundant to ample” reserves, the minutes said.
7. So how much longer will QT last?
The Fed gave no indication in its May 1 announcement what the timeline might be. Minutes of that policy meeting are expected to be released May 22, and we may know more then. Roberto Perli, who oversees the Fed’s securities portfolio at the New York Fed, said on May 8 that policymakers now have more time to evaluate changes to market conditions. The new pace of QT prompted Citigroup Inc. to delay its projected timing for the end of QT, to the second quarter of 2025 — barring a recession.
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