On June 1, 2022, the Federal Reserve began a policy of “quantitative tightening,” a process that aims to reduce the size of its over eight-trillion-dollar balance sheet. While the aim of this program is to fight inflation, quantitative tightening may also hamper economic growth.
The Federal Reserve’s balance sheet expanded during a period of quantitative easing.
At the onset of the 2020 recession, the Federal Reserve began a policy of quantitative easing, which included the purchase of billions of dollars’ worth of bonds each month to help stabilize and grow the economy. From June 2020 to November 2021, these purchases were made at a steady rate of $120 billion per month, according to The Wall Street Journal. Beginning in November 2021, the Federal Reserve began to taper the amount of these purchases.
By the end of quantitative easing, the Federal Reserve had doubled the size of its balance sheet because it purchased $4.5 trillion of Treasury securities and agency mortgage-backed securities.
The Federal Reserve recently reversed course and began to shrink its balance sheet.
The impetus for this change in policy is rising inflation. As measured by the Personal Consumption Expenditures (PCE) Price Index, inflation rose 4.9% in April 2022, according to data released by the Bureau of Economic Analysis on May 27, 2022. This marked the thirteenth consecutive month when the PCE Price Index was above the Federal Reserve’s target 2% rate.
Starting on June 1, 2022, the Federal Reserve began its process of quantitative tightening, also known as QT. For the next three months, the central bank will reduce its balance sheet by $47.5 billion each month. The Federal Reserve will increase the pace to $95 billion per month after Labor Day.
This change in Federal Reserve policy may impede economic growth.
It is unknown what impact on the greater economy this policy of quantitative tightening may have. In a press conference in May 2022, Federal Reserve Chairman Jerome Powell said the effects of QT will fall into “very wide uncertainty bands—very wide. We don’t really know.”
Past attempts by the Federal Reserve to reduce its balance sheet have led to negative reactions from lenders and added pressure to financial markets. On June 1, 2022, Reuters reported, “The last time the Fed reduced its balance sheet, it ended badly. Rates to borrow in the crucial overnight repurchase agreement market surged in Sept. 2019, which analysts attributed to bank reserves falling too low as the Fed ran down its balance sheet.”
Andrew Hunter, a senior U.S. economist at Capital Economics, believes QT could hinder markets. In a note, Hunter wrote, “The main impact will come indirectly via the effects on financial conditions, with QT putting upward pressure on Treasury term premiums, which, alongside a further slowdown in economic growth, will add to the headwinds facing the stock market.”
Analysts at Wells Fargo hold a similar view. In a note released in May 2022, the Wells Fargo Investment Institute said that QT will add pressure to markets, stating, “Along with other forms of tightening in financial conditions, this represents a further headwind for risk assets.”
The Federal Reserve’s latest policy decisions may impact U.S. economic growth. As market uncertainty increases, more individuals may look to safe-haven assets as stores of wealth.
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