Overview of the Potential End to Quantitative Tightening

The market anticipates that the Federal Reserve will conclude its three-year Quantitative Tightening (QT) program this week, a move designed to ease pressure on banks amid growing concerns about tightening liquidity in money markets. Earlier this month, some bank lenders tapped a federal emergency funding tool at levels reminiscent of the COVID-19 pandemic.

Background of Quantitative Tightening and Its Impact

Since initiating the QT program in June 2022, the Fed has allowed over $2 trillion of U.S. Treasury bonds and mortgage-backed securities to mature naturally from its balance sheet without reinvestment, effectively tightening the financial environment.

Expert Opinions on the Timing of the Decision

"The Fed ending QT this month has rapidly become consensus," said Krishna Guha, vice chairman at Evercore ISI. Rich Clarida, former Fed vice chair and now at Pimco, added, "It’s a close call. Even if we don’t get a formal decision, we’ll get a very strong indication that they will end QT in December."

Interest Rate Expectations

Fed Chair Jerome Powell hinted earlier this month that the central bank would end QT “in coming months,” also strongly implying an intention to cut interest rates by 25 basis points for the second consecutive month.

Factors Influencing the Decision

Against a backdrop of weakening labor market signs and fading concerns about the trade war fueling inflation, the market has almost fully priced in expectations that the Fed will cut the federal funds target rate range to 3.75-4% on Thursday.

QT vs. QE: A Reverse Course

QT is the reverse operation of the Federal Reserve’s Quantitative Easing (QE) policy, which policymakers last deployed during the COVID-19 pandemic to avert economic and financial crises. The Fed has used both QE and QT multiple times since 2009 as another tool to influence the financial environment.

Mechanism of QE and QT

QE refers to a central bank increasing the money flow in the economy by purchasing assets such as bonds or mortgage-backed securities. This mechanism helped bolster market confidence during times of financial stress, such as after the Lehman Brothers collapse. Under QT, the Fed takes the opposite approach, allowing the bonds it purchased to roll off its balance sheet after they mature without repurchasing them.

Adjusting the Pace of QT

The Fed slowed the pace of QT in April this year, reducing the monthly runoff of U.S. Treasury bonds from $25 billion to $5 billion. Concurrently, it maintained the monthly runoff of mortgage-backed securities at a maximum of $35 billion.

Impact of QT on Bank Liquidity

This runoff operation drains liquidity from the banking system, meaning that loan institutions hold fewer reserves at the Fed—thereby making funding costs more susceptible to upward pressure.

Adequate Liquidity Levels

Federal Reserve officials had previously agreed to end QT once the U.S. banking system showed signs of transitioning from a so-called “ample” liquidity level to possessing “sufficient” reserves. Officials defined a “sufficient” state as a just-right level of liquidity—one where banks are able to meet their funding needs at prices consistent with the official benchmark rate, but without being awash in excess cash.

Emergency Support Tools

Though there are no widespread signs of stress at present, usage of the New York Fed’s Standing Repo Facility—an emergency support tool that charges rates higher than the central bank’s benchmark rate—has recently reached pandemic-era levels.

Avoiding Past Mistakes

Analysts believe the Fed may also want to act now to avoid repeating the mistakes of its last quantitative tightening experiment in September 2019, when banks’ short-term funding costs soared above the Fed’s target range.

Fears of Liquidity Shock

"The biggest thing driving the Fed is the fear of a liquidity shock," said Diane Swonk, chief economist at KPMG.

Controversy Surrounding Balance Sheet Usage

The Fed’s use of its balance sheet has been controversial. Though QE prevented market meltdown during the pandemic, critics argue it also fueled the worst surge in inflation in a generation. At $6.59 trillion, the Fed’s balance sheet is still more than $2 trillion higher than it was before the pandemic. At the time of the global financial crisis in 2008, that figure was less than $1 trillion.

Difficulty in Shrinking the Balance Sheet

"Shrinking the balance sheet is not as easy as expanding it. The overnight lending market that existed before the financial crisis is gone," Swonk said.

Criticism of QE Programs

U.S. Treasury Secretary Janet Yellen recently slammed the Fed’s QE programs as "mission creep" and claimed its balance sheet policies exacerbated inequality, an accusation Fed officials have denied.