Bloomberg columnist Jonathan Levin wrote in his latest article that it is time for the Federal Reserve to end quantitative tightening (QT). The following content is the author's opinion.
The Fed’s asset purchase program, or quantitative easing, has helped save the U.S. economy twice — first during the financial crisis and again during the coronavirus pandemic. The program’s longevity depends on policymakers’ ability to shut it down when it’s no longer needed without causing unnecessary volatility in markets. That makes the next 12 months critical.
Currently, the Fed allows up to $60 billion in Treasury bonds and up to $35 billion in mortgage-backed securities to mature each month. This QT has drained liquidity from the financial system, the opposite of the effect of quantitative easing.
So far, the Fed’s QT has gone well. Money markets—the area where most doomsayers tend to predict QT disruptions—have been functioning relatively well. Although a spike in secured overnight funding rates late last year sparked a panic, the move has proven small and short-lived. Treasury buyers, meanwhile, have been able to absorb the increased supply of government bonds without major indigestion. Bank reserves have fallen (a deliberate move by the Fed) but remain well above what most policymakers consider “ample.”
Now, Fed policymakers must avoid relying on luck and announce a timetable for slowing and ending QT in the coming months.
First, there is no real benefit to continuing QT at its current pace. Data from the Bureau of Economic Analysis later this week should show that inflation is close to the Fed's 2% target. The most reasonable estimates also suggest that QT is equivalent to one or two rate hikes at most. The Fed's main tool for fighting inflation is the policy rate, and slowing the pace of QT sooner rather than later will not actually sacrifice price stability.
Second, the 2019 experience taught the Fed a lesson. At the time, the Fed had been "normalizing" its balance sheet for about two years, with the effect of removing excess bank reserves from the financial system, a process that former Fed Chair Janet Yellen once said was like "watching paint dry." But in September 2019, the repo market, where financial institutions finance themselves, experienced major disruptions, forcing the Fed to intervene and halt the entire QT process.
That’s why, a year and a half into the latest round of QT, there’s some palpable nervousness on Wall Street. Jamie Dimon recently told JPMorgan Chase investors that the Fed’s policy of shrinking its balance sheet is one of the main downside risks he’s watching. Bill Gross, co-founder of Pacific Investment Management Co. (PIMCO), called on the Fed to stop the process as soon as possible on Bloomberg TV this week. Minutes from the Fed’s Dec. 12-13 meeting showed that “several participants” believed it was appropriate to begin discussing potential conditions for an eventual slowdown in QT.
The Fed is committed to operating in an environment where bank reserves are “ample,” and there is a flurry of speculation among economists and Wall Streeters about what that means. At $3.5 trillion (about 15% of total assets), bank reserves are above the 13% that New York Fed President John Williams flagged as appropriate in a 2022 paper and well above 2019’s lower levels.
Before the financial crisis, the Fed used a scarce reserve framework. Under this framework, the Fed intentionally controlled the size of reserves and then changed the size of reserves in the system through open market operations to achieve the goal of controlling interest rates. After the financial crisis, QE operations made reserves in the banking system no longer scarce, and the Fed switched to a sufficient reserve framework.
Of course, some worry that the Fed’s balance sheet is itself a risk. They point out that the Fed has incurred operating losses in its most recent fight against inflation. Because it has accumulated longer-dated assets during its previous quantitative easing, it has locked in low passive income rates and has been paying high rates to short-term borrowers. This is an unnecessary worry in the long run. When interest rates are rock-bottom, the Fed is remitting large amounts of profits to the Treasury to cut the deficit. Over the course of the business cycle, the Fed should return to profitability and it does not need to be frantically shortening the duration of its asset portfolio.
Policymakers like to think they have a quantitative understanding of how much liquidity can safely be withdrawn from the banking system. But in fact, multiple post-mortems show that 2019 was the result of a combination of factors. Already low reserve balances, combined with the impact of large corporate tax outflows and the settlement of $54 billion in Treasury bonds. It was a perfect storm, and the next one may be hard to foresee.
The Fed has a little extra buffer this time. Under normal circumstances, QTs directly reduce bank reserves. When the Fed stops rolling over its holdings, banks would theoretically step in and buy more Treasuries at auction, effectively emptying out some of their reserves. But in recent years, money market funds have poured money into the Fed’s reverse repo facility, creating a reservoir of pent-up demand for bonds that has been absorbing some of the shock from the recent QTs. Data suggest the reverse repo buffer could be exhausted in a few months, leading some observers to brace for another drop in bank reserves.
At the same time, the Fed simply does not need to tighten aggressively again, as this would risk destroying hopes for a "soft landing" and convincing people that all the Fed's fights against inflation will inevitably end in recession and rising unemployment. This would also confirm all the critics who said that once the QE "genie" was released, it could not be safely put back in the bottle. In this cycle, the Fed has so far proved those critics wrong, ensuring that asset purchases will remain part of its toolkit for years to come.
The article is forwarded from: Jinshi Data