Explained: Quantitative Tightening vs. Quantitative Easing
Let's take a look at how FED uses these tools to increase/reduce liquidity in the economy and to combat inflation nowadays
This type of contractionary monetary policy has only been done in the US once before (2017 - 2019). This tool is used to reduce liquidity in the economy to combat inflation. Before diving into the mechanics of how this works, let's briefly take a step back and provide some context. The Fed's balance sheet has grown from $4.3T in March 2020 to roughly $9T now.
How did this happen? In March 2020, at the beginning of the pandemic, the Fed started its Quantitative Easing (QE) program to stimulate the economy.
What is QE? QE is when the Fed buys longer-term Treasury securities and mortgage-backed securities (MBS) from the open market using reserves that it creates (essentially printing money). The result: new money is added to the system, interest rates fall & the Fed's balance sheet expands. So the Fed's balance sheet has more than doubled in the last two years and the private sector (commercial banks) are awash with excess reserves. Now, the Fed is pushing the brakes and aiming to slow down the economy. They can do this through QT, the opposite of QE.
QT: how does it work? Normally, the Fed reinvests the proceeds from the principal payments of maturing Treasuries into newly issued Treasuries. In doing so, they replace maturing bonds. This is how they maintain the size of their balance sheet.
With QT, the Fed reduces the amount of money that's reinvested into new Treasury securities. Treasuries that are not reinvested "run-off" the balance sheet. This allows them to reduce the value of their balance sheet. Because of this, you'll see QT often referred to as "Balance Sheet Run-Off" or "Balance Sheet Normalization."
The Fed sets a monthly cap on how many Treasuries can mature without having its proceeds reinvested. These reductions must be gradual and measured since we don't know what level of bank reserve balances need to be maintained in order not to cause a shock in the financial system. Once the cap is met, any extra money from maturing securities is reinvested.
Effectively, the Fed's balance sheet should shrink by roughly $1T annually. This is a much faster pace than the last round of QT in 2017-2019. Powell expects that it may take around three years for the balance sheet to normalize, although there is no fixed timeframe.
How might QT affect the price of Treasuries and Mortgage-Backed Securities? The price of these are set by supply and demand. Supply is not changed, but demand should decrease since the Fed is no longer a buyer of these securities. Since the private sector is now the main buyer, prices may have to reduce in order for demand to meet supply. Lower Treasury prices lead to higher yields. Lower MBS prices lead to higher mortgage rates.
During QE, the Fed bought securities at any price as they could create reserves to fund their purchases. This is why we saw Treasury yields and Mortgage rates fall rapidly during QE. These markets were propped up by Fed demand, causing upward price pressure and lower yields. But private investors are more price-conscious, and their demand is not as inelastic (they do not have endless reserves). As a result, we've seen a rise in yields and mortgage rates ever since Powell switched his tone to hawkish and announced a taper in QE asset purchases.
There is also very little data on the effects of QT on the economy and markets as there has only been one cycle in the past. These factors breed fear and uncertainty, and hence we've seen heightened volatility in equity markets.