What Is the Fed’s ‘Quantitative Tightening’ and How Does It Work?

The US Federal Reserve’s process of gradually withdrawing the trillions of dollars it injected into the financial system during the Covid-19 pandemic is well into its second year. The last time the Fed carried out such “quantitative tightening,” starting in 2017, it prompted unexpected problems in financial markets that forced policymakers to abandon the program early. Officials say they learned lessons from that episode, but market participants disagree on how much longer QT can last without again disrupting markets and putting the broader economy at risk.

1. What’s quantitative tightening?

The easy answer is that it’s the opposite of quantitative easing, or QE. The late monetary economist Milton Friedman proposed a type of QE decades ago, and the Bank of Japan pioneered its use in 2001. Japan’s central bank resorted to QE because it had already reduced its benchmark interest rate to near zero and needed new tools to stimulate the economy. Other central banks have done much the same as they approached or reached 0% policy rates. In 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, in time, has the effect of removing bank reserves from the financial system that QE had inflated. It happens in a series of operations. When the 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 is 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. The current pace allows a maximum of $60 billion in Treasuries and $35 billion in mortgage-backed securities to mature every month without replacement. That $95 billion pace is nearly double the peak rate of $50 billion the last time the Fed trimmed its balance sheet, from 2017 to 2019. The runoff of the bond portfolio has brought the total size of the Fed’s balance sheet down by roughly $1 trillion as of November, from a record peak of near $9 trillion reached in early 2022. The balance sheet had more than doubled after Covid struck as the Fed snapped up trillions of dollars’ worth of securities.

4. So has QT been destroying bank reserves?

Although this is an effect of QT, it hasn’t happened much lately. That’s because the money the Fed pumped into the system with QE moved around over time, and a whole lot of it flowed into something at the Fed called the reverse repurchase facility, or RRP. Because this tends to be used by money market funds, it’s not as directly connected to the flow of credit in the economy as commercial bank reserves are. So far, QT has mainly been causing a shrinkage in the RRP, rather than in reserves. But that will change, and once the RRP is drained, reserves will come down.

5. Then QT has been painless so far?

Not quite. Regardless of where the liquidity is being drained from — reserves or RRP — the process is still forcing the Treasury to borrow more from the public. And that’s contributing to an increase in borrowing costs. Essentially, just as QE drove down interest rates, QT can be expected to push them up. Fed Chair Jerome Powell said on Nov. 1 that QT had indeed contributed to the sharp increase in yields on longer-term Treasuries seen in 2023. And that rise has reverberated across the financial system, with 30-year fixed rate mortgages approaching 8%, on average, in November. That’s the highest since 2000, and it’s driving up housing costs. Plus, as companies refinance maturing loans, higher interest costs will eat into their revenue and may reduce their appetite to invest and hire.

6. 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 period of the year when there tends to be seasonally high demand for cash — a declaration by 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 rate hikes, and in March 2019, it announced the phasing out of QT. Despite that, by September 2019, there were spikes in borrowing costs in an essential part of the economy’s financial plumbing — the repo market. That suggested there were simply 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.

7. How do policymakers think about things now?

Powell, speaking to lawmakers in July, said of the market turmoil of 2019 that “we didn’t see it coming.” This time, “we have experience,” he said. The Fed has also specifically committed to keep “ample” reserves in the system and has advised that “to ensure a smooth transition,” it intends “to slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level it judges to be consistent with ample reserves.” Powell said on Nov. 1 that Fed policymakers weren’t “talking about or considering” any change in the pace of QT yet.

8. How much longer will QT last?

It’s tough to predict, because nobody knows exactly how much in bank reserves the financial system needs. Today they are well in excess of $3 trillion. Longtime bond-market participant Lou Crandall, chief economist at Wrightson ICAP, is among those who argue the Fed should call it off after the RRP is completely drained. Morgan Stanley economists, extrapolating the current pace of decline in the RRP, said in a Nov. 12 note that that suggests “tapering of QT likely starts in June next year.” The bank predicted the eventual end in early 2025. But the previous episode showed problems can crop up quickly and unexpectedly, a prospect that’s likely to keep investors and policymakers on their toes as the latest QT program extends.