What is Quantitative Tightening (QT)?
Quantitative Tightening (QT) refers to monetary policies this contract, or reduce, the Federal Reserve System (Fed) balance sheet. This process is also known as balance sheet normalization. In other words, the Fed (or any other central bank) shrinks its monetary reserves either by selling treasures (government bonds) or by allowing them to mature and withdrawing them from its treasury. This removes liquidityor money, financial markets.
It’s the opposite of quantitative easing (QE)a term that has become entrenched in the vernacular of the financial market since the 2008 financial crisiswhich refers to monetary policies adopted by the Fed that extend balance sheet.
Key points to remember
- Quantitative tightening (QT), also known as balance sheet normalization, refers to monetary policies that contract or reduce the balance sheet of the Federal Reserve (Fed).
- QT is the opposite of quantitative easing (QE).
- The Fed implements QT by selling Treasuries (government bonds) or letting them mature and removing them from its cash balances.
- The risk of QT is that it has the potential to destabilize financial markets, which could trigger a global economic crisis.
Understanding Quantitative Tightening (QT)
The Fed’s primary objective is to keep the US economy running at peak efficiency. Thus, its mandate is to adopt policies that promote maximum employment while ensuring that inflationary forces are kept at bay. Inflation refers to the monetary phenomenon where the prices of goods and services in the economy increase over time. High levels of inflation erode consumers’ purchasing power and, if left unaddressed, could negatively impact economic growth. The Fed is very aware of this and tends to be quite proactive if they have evidence of this happening.
The first step the Fed takes to contain runaway inflationary pressures is to shift the federal funds rate upper. In doing so, the central bank influences the interest rate that banks charge when they lend to their customers, whether commercial or residential. An example of a residential loan would be mortgage rates. An increase in the federal funds rate would cause mortgage rates and monthly payments to rise, which would lead to lower demand for properties, causing prices to fall or stabilize.
Another way to influence interest rates upwards is through a process called quantitative tightening (QT). As mentioned above, this can be accomplished in two main ways: outright sales of government bonds in the secondary Treasury market or non-repurchase of the bonds that the Fed holds at maturity.
Both methods of implementing QT would increase the supply of obligations available on the market. The main objective is to reduce the amount of money in circulation to contain the escalation of inflationary forces. The process by which this is done invariably results in higher interest rates.
Knowing that supply would continue to increase through additional sales or lack of government demand, potential bond buyers would demand given to buy these offerings. These higher yields would increase borrowing costs for consumers, prompting them to be more cautious when taking on debt. This should dampen demand for assets (goods and services). Less demand means stabilizing or lowering prices and controlling inflation, at least in theory.
Is inflation a bad thing?
A point to note about inflation: Inflation is necessary – necessary, in fact – for the growth of a healthy and stable economy. It becomes a problem when it starts accelerating to the point where it outpaces wage growth. For example, if a person earns $4,000 a month and has a budget of $500 for groceries, any increase in the cost of that grocery while their income remains the same would reduce their ability to spend on other things or saving for investment purposes. The net result of the decrease in purchasing power is that they are “poorer”.
Most economists believe that an annual inflation rate of 2-4% in a healthy economy is manageable, as wage growth expectations to keep up with that rate are reasonable. However, it is unreasonable to expect wages to keep pace if inflation starts accelerating much more.
QT vs Tapering
Degressive is the transition between QE and QT. This is essentially the term used to describe the process by which asset purchases implemented by QE are gradually reduced. Typically, this involves reducing the amount of maturing bonds repurchased by the Fed until it is zero, in which case any further reduction becomes QT.
On May 4, 2022, the Fed announced that it would embark on QT in addition to raising the federal funds rate to counter emerging signs of accelerating inflationary forces. The Fed’s balance sheet had soared to nearly $9 trillion due to its QE policies to combat the 2008 financial crisis and the COVID-19 pandemic.
The highlights are that starting June 1, 2022, the Fed would let about $1 trillion in securities ($997.5 billion) mature without reinvestment over a 12-month period. Fed Chairman Jerome (Jay) Powell estimates that this amount is approximately equal to a 25 basis point rate hike in terms of effect on the economy.
The caps will be set at $30 billion per month for treasury bills and $17.5 billion per month for mortgage-backed securities (MBS) for the first three months. Subsequently, these ceilings will be raised to $60 billion and $35 billion respectively.
Quantitative tightening (QT) risk
The risk of QT is that it has the potential to destabilize financial markets, which could trigger a global economic crisis. No one, let alone the Fed, wants a sell-off in the stock and bond markets caused by widespread panic over a lack of liquidity. This type of event, rightly named conical tantrumhappened in 2013 when then-Fed Chairman Ben Bernanke mentioned the simple possibility of phasing out asset purchases.
However, QT is another arrow in the Fed’s quiver to stem the dangers posed by an overheated economy.
Quantitative Tightening vs Quantitative Easing: What’s the Difference?
Quantitative easing refers to monetary policies that expand the balance sheet of the Federal Reserve (Fed). The Fed does this by entering the open market and buying longer-term government bonds as well as other types of assets, such as mortgage-backed securities (MBS). This adds money to the economy, which serves to lower interest rates. Quantitative tightening, on the other hand, does the exact opposite. It reduces the Fed’s balance sheet by selling treasury bills (government bonds) or letting them mature and removing them from its cash balances. This takes money out of the economy and leads to higher interest rates.
Is tapering the same as quantitative tightening?
No. Tapering is the process of reducing the pace of quantitative easing (QE), but the balance sheet is still expanding, albeit at a slower pace. Quantitative tightening (QT) reduces the balance sheet. Simply put, the decrease occurs between QE and QT.