US President Joe Biden met earlier this week with US Fed Chief Jerome Powell and Treasury Secretary Janet Yellen to discuss “fighting inflation”, a “top economic priority” for the US administration. Powell said that with the Fed implementing its “quantitative tightening” or QT policy from June 1, there could be a risk of market volatility.
Quantitative tightening, or QT, is a twin quantitative easing, or QE. Under it, over the next three months the Fed will stop reinvesting proceeds from its $9 trillion bond stack to shrink its balance sheet by $47.5 billion each month. Then, starting in September, the Fed will step up the tightening process at a rate of reduction of $95 billion per month. The intended overall effect is to reduce the Fed’s balance sheet by about $9 trillion in an effort to combat historically high inflation in the United States.
What is QT? Simply put, QE creates and injects money into the system. QT will withdraw money from the system and destroy it.
During QE, the Fed buys long-term securities, paying for them by increasing reserve balances, which are more liquid assets than long-term securities. Therefore, QE adds to the liquidity in the system, and therefore reduces the liquidity premium on the most liquid bonds and increases yields. Thus, QE raises yields on the most liquid assets, Treasuries.
During the QT, the Fed will allow the bonds it holds to mature without buying new ones. The US Treasury will pay the Fed the principal amount of each bond. The Fed will destroy this money received from the US Treasury. To compensate for what it will pay to the Fed, the US Treasury will raise new money by selling new debt to the public, thereby draining liquidity (cash or bank deposits) from the financial system, replacing it with Treasury paper. .
The Fed is already draining cash from the financial system through the “Reverse Repurchase Program,” or RRP, under which investors give money to the Fed to receive Treasuries (and a return) in return. It also reduces liquidity, replacing it with Treasury. paper.
Theoretically, investors can buy the new treasury bills instead of donating money under the RRP, without affecting liquidity. But market watchers do not expect this and the RRP and QT are likely to absorb liquidity side by side. Liquidity could also be absorbed by a third channel, bank loans, rather a slowdown in bank loans, while the US economy is cooled by monetary tightening. Remember that when banks make loans or buy an asset, they create money. Bank credit was growing at a breakneck pace in the United States during the pandemic. Over the past year, it has grown by $1.5 trillion. Slower bank credit growth will therefore also reduce liquidity.
At full speed in September, the Fed’s balance sheet – which has shrunk from $2.3 trillion in 2010 to $9 trillion currently – will be reduced at a rate of $1.1 trillion a year, a rate of reduction much faster than in 2018, the last time the balance sheet was reduced to reverse post-global financial crisis QE. The decline should be accelerated, because US inflation is at a historically high level this time and the recovery is much faster and stronger than last time.
What happens when the Fed’s balance sheet shrinks? Zero-rate, low-risk assets are replaced by interest-bearing, higher-risk Treasury securities. There is less liquidity in the system, more risk. But this does not necessarily imply a more risky system, as risk aversion can also increase with increasing risk.