Quantitative Tightening (QT)

What Is Quantitative Tightening (QT)?

Quantitative tightening (QT) refers to monetary policies that 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 central bank) shrinks its monetary reserves by either selling Treasurys (government bonds) or letting them mature and removing them from its cash balances. This removes liquidity, or money, from financial markets.

It is the opposite of quantitative easing (QE), a term that has become ingrained in the financial market’s vernacular since the 2008 financial crisis, which refers to monetary policies adopted by the Fed that expand its balance sheet.

Understanding Quantitative Tightening (QT)

The Fed’s primary goal is to keep the U.S. economy operating at peak efficiency. Thus, its mandate is to enact 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 rise over time. High levels of inflation erode consumer buying power and, if not addressed, could negatively affect economic growth. The Fed is very cognizant of this and tends to be quite proactive if it has evidence that this is happening. 

The first step that the Fed takes to rein in runaway inflationary pressures is to move the federal funds rate higher. In doing so, the central bank influences the interest rates that banks charge when lending to their customers, both corporate and residential. An example of residential lending would be mortgage rates. Hiking the federal funds rate would lead to higher mortgage rates and monthly payments, which in turn should cause demand for properties to fall, leading to lower, or stabilization in, prices.

Another way to influence interest rates higher is to resort to 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 not buying back the bonds that the Fed holds when they mature.

Both methods of implementing QT would increase the supply of bonds available in the market. The main focus is on reducing the amount of money in circulation to contain the escalating inflationary forces. The process by which it is done invariably results in higher interest rates.

Knowing that supply would continue to increase through additional sales or the lack of government demand, potential bond buyers would require higher yields to buy these offerings. These higher yields would raise the borrowing costs for consumers, causing them to be more cautious about going into debt. This should dampen demand for assets (goods and services). Less demand means stabilization or lowering of prices and a check on inflation, in theory at least.

Is Inflation a Bad Thing?

A point of note about inflation: Inflation is needed—necessary, in fact—for the growth of a healthy, stable economy. It becomes a problem when it starts accelerating to the point where it outpaces wage growth. For example, if an individual makes $4,000 per month and budgets $500 for groceries, then any increase in the cost of those groceries while their income stays the same would decrease their ability to spend on other things or save for investing purposes. The net result of the decrease in purchasing power is that they are “poorer.”

Most economists feel that an annual 2% to 4% inflation rate in a healthy economy is manageable, as expectations of wage growth to keep pace with that are reasonable. However, it is unreasonable to expect wages to keep pace if inflation starts accelerating much higher.

QT vs. Tapering

Tapering is the segue from QE to QT. Essentially, it is the term used to describe the process whereby the asset purchases implemented by QE are gradually cut back. Typically, this entails reducing the amount of maturing bonds being repurchased by the Fed until it is down to zero, at which point any further reduction becomes QT.

QT 2022

On May 4, 2022, the Fed announced that it would embark on QT in addition to raising the federal funds rate to thwart the nascent signs of accelerating inflationary forces. The Fed’s balance sheet had ballooned to almost $9 trillion due to its QE policies to combat the 2008 financial crisis and the COVID-19 pandemic.

The salient points are that, beginning June 1, 2022, the Fed would let about $1 trillion worth of securities ($997.5 billion) mature without reinvestment in a 12-month period. Fed Chairman Jerome (Jay) Powell estimates that this amount is approximately equal to one 25-basis-point rate hike in terms of its effect on the economy.

The caps will be set at $30 billion per month for Treasurys and $17.5 billion per month for mortgage-backed securities (MBS) for the first three months. Subsequently, these caps 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, least of all the Fed, wants a severe sell-off in the stock and bond markets caused by widespread panic due to a lack of liquidity. This type of event, aptly named a taper tantrum, occurred in 2013 when then-Fed Chairman Ben Bernanke brought up the mere possibility of tapering asset purchases.

However, QT is another arrow in the Fed’s quiver to stem the dangers posed by an overheating economy.