An overlooked Fed policy comes into focus as central bankers weigh how to slow ‘QT’

Central bank officials are expected this week to discuss a strategy for how to slow the shrinking of the Federal Reserve’s balance sheet, a lesser-known policy tool they have been using to tighten financial conditions while fighting inflation.

Over the last two years, the Fed has shed roughly $1.5 trillion in Treasury and mortgage bonds that it accumulated while trying to stimulate the economy during the early parts of the pandemic, at a pace of roughly $100 billion every month.

Allowing those bonds to mature acts to push up long-term interest rates as more bonds have to be snapped up by other investors.

This so-called “quantitative tightening,” or QT, is a key tool — along with a series of hikes to the Fed’s benchmark federal funds rate — that the central bank is using to cool the hottest bout of inflation since the 1980s.

Now that inflation is coming down, the question is when the Fed could start slowing the pace of its balance sheet runoff. That subject is expected to be on the table Tuesday and Wednesday during a meeting of the Federal Open Market Committee, along with the future direction of rates.

“Moving more slowly can reduce the risk of an accident that would require us to stop too soon,” said Dallas Fed president Lorie Logan, who oversaw a balance sheet wind-down in 2019 when she was at the New York Fed.

“This strategy will mitigate the risk of undesired liquidity stresses from QT.”

‘Ample’ reserves

When could this slowing begin? It could depend on a level of money market reserves housed at the Fed known as the overnight reverse repurchase facility, or ON RRP, which is separate from money that ends up in bank reserves.

That ON RRP facility has been shrinking, and some Fed officials want to slow the runoff once that facility is nearly out of cash.

As long as there are significant balances in the ON RRP facility, Logan said, officials can be confident that liquidity is more than ample. But once the ON RRP is empty, there will be more uncertainty about how much excess liquidity remains.

New York Fed President John Williams has said the point of when a slowdown could start would be when balances are somewhat above the level the Fed judges to be consistent with “ample” reserves — a level that allows the Fed to continue controlling short-term interest rates and avoid volatility in money markets.

“I don’t think we can identify the ample level in advance,” Logan said in a recent speech. “We’ll need to feel our way to it by observing money market spreads and volatility.”

For Logan, that means watching the spread between money market rates and the interest rate on bank reserve balances.

When reserves are ample, money market rates should not move much with fluctuations in reserve supply. But if reserves are below ample and money market rates are meaningfully above the interest on reserve balances, banks face an implicit tax on liquidity.

This can make the financial system less safe and less efficient. “Proceeding more gradually may allow the Fed to eventually get to a smaller balance sheet by providing banks with more time to adjust,” Logan said.

From QE to QT

Before there was QT, there was QE, or “quantitative easing.”

That began in late 2008 under Fed chair Ben Bernanke when the Fed first began snapping up large amounts of bonds as a way to provide a much-needed boost to an economy then tested by a crushing financial crisis.

It eventually did two more rounds of quantitative easing — known as QE2 and QE3 — and attracted criticism from observers who argued the programs were responsible for speculative froth and market bubbles.

The Fed tried QT once before, starting in 2017, when Janet Yellen was in charge of the central bank. But that shrinking of its portfolio drained bank reserves held at the central bank and led to some unexpected turbulence.

In 2019, after Powell had taken over at the Fed, it created a cash crunch that caused rates to jump on short-term “repo” loans banks make to each other. The upheaval forced the Fed to begin buying again, which calmed markets.

That buying ramped up aggressively in 2020 when the pandemic started as a way of giving the economy another boost and loosening financial conditions.

The Fed’s securities holdings topped out at $9 trillion in 2022 — the year it decided to pivot and act aggressively to tamp down rising inflation.

Since QT began roughly two years ago, the Fed’s balance sheet has shrunk to around $7.5 trillion, as officials have let just under $100 billion per month in Treasury and mortgage bonds mature and not be replaced.

‘Short of a shoo-in’

Fed officials view QT and interest rates on separate tracks. Fed governor Chris Waller says changes to the Fed’s balance sheet will be independent of rate cuts.

“Balance sheet plans are about getting liquidity levels right and approaching ‘ample’ at the correct speed,” Waller said in a speech on March 1.

“They do not imply anything about the stance of interest rate policy, which is focused on influencing the macroeconomy and achieving our dual mandate.”

Waller said he would like to see the Fed’s holdings of mortgage-backed securities go to zero and for the Fed to have a balance sheet of mainly Treasury securities, in line with the thinking of other officials.

Both former St. Louis Fed president Jim Bullard and former Kansas City Fed president Esther George said they aren’t expecting a decision on the balance sheet at this meeting.

“I think what they’re trying to avoid is running into problems that they’ve had before, getting too close to the demand for reserves and causing some market functioning issues,” said George.

But Benson Durham, an analyst with Piper Sandler, said “it’s quite possible, although short of a shoo-in” that Fed officials do state in their policy statement this week that they expect to begin reducing the pace of balance sheet runoff at a coming meeting.