The Fed Is Tightening More Than It Says

Benn Steil ، Elisabeth Harding,

The Fed Is Tightening More Than It Says

The Fed Is Tightening More Than It Says

The Fed Is Tightening More Than It Says© Provided by Barron’s

About the authors: Benn Steil is director of international economics at the Council on Foreign Relations. Elisabeth Harding, formerly of the Federal Reserve Bank of St. Louis, is an analyst at CFR.

On Nov. 1, the U.S. Federal Reserve opted to keep its policy rate steady for a second straight meeting, with Chair Jay Powell hinting that its aggressive tightening cycle, begun in March 2022, might be over. Stock and bond markets roared for three straight days—recording their best week yet this year.

But Powell has also dismissed the suggestion that the Fed might stop paring down its balance sheet, which is much larger than it considers appropriate for post-pandemic economic conditions. This paring operation, otherwise known as “quantitative tightening,” or QT, involves allowing $95 billion in maturing Treasury and mortgage securities to roll off the Fed’s balance sheet each month. Powell has maintained that this process will have only minor effects on financial conditions relative to those of its policy-rate rises.

We believe, however, that QT will have a considerably larger, and indeed growing, effect in tightening financial conditions across the economy over the coming 18 months—an effect of which the market appears unaware.

Let us explain.

Balance-sheet reductions influence the cost of short-term borrowing by changing the supply of long-term securities in the hands of the public, which in turn increases the term premiums on long-term securities—that is, the compensation investors demand for bearing the risk that rates may change over the life of those securities. Since the Fed’s policy rate similarly influences long-term rates, balance-sheet operations and rate hikes are effectively substitute policy tools.

What is curious about quantitative tightening, in contrast to quantitative easing (or buying securities), is that the Fed has typically downplayed its effects in monetary policy, preferring to present it as a technical operation that can be carried on in the background with only modest effect on financial conditions. This despite the fact that the exit of a big bond buyer from the market (the Fed) should depress bond prices, and therefore boost their yield—along with interest rates on borrowing in the wider market.

Back in 2017, then-Fed chair Janet Yellen observed that the central bank did “not have any experience in calibrating the pace and composition of asset redemptions and sales to actual prospective economic conditions,” and that “its primary tool for scaling back monetary policy accommodation would [therefore] be influencing short-term interest rates.” In May 2022, Powell estimated that QT was “sort of” equivalent to one-quarter percent in rate hikes over the course of a year. He affirmed that view at this month’s press conference, saying that QT’s effect on financial conditions was likely “relatively small.”

Here is where we diverge from the Fed. The figure below shows the path through time of two interest rates. The lower line shows the path of the Fed’s policy rate going back to April 2022, and its projected path forward over the coming two years. The upper line shows what we call the “QT-equivalent policy rate,” which accounts for the effect of QT. The QT-equivalent rate is the policy rate needed without QT to have an effect on financial conditions equivalent to that produced by the actual policy rate with QT. Our calculations apply to current balance-sheet, policy-rate, and gross domestic product data the same methodology used by Fed economists in a technical paper published in June 2022—one month after Powell issued his quarter-point estimate.

What we find is that today’s policy rate of 5.375% is, under the current QT roll-off schedule, having roughly the same impact on financial conditions as a policy rate of 5.763% without QT. That’s a gap of 39 basis points, or 39 hundred of a percent. But the effect of QT rises sharply going forward, as $95 billion in assets continue to roll off the balance sheet each month, before reaching a high of 100 basis points—or one full percent—in May 2025.

To the extent that the Fed and the market are not accounting for the fact that the QT-equivalent policy rate will, going forward, be substantially higher than the actual policy rate, they are both underestimating how tight monetary policy actually is. And the market is therefore overestimating the value of stocks and bonds—both of which have been hyper-sensitive to expectations of Fed rate policy shifts.

The broader lesson is that the market and the media need to judge the stance of monetary policy looking beyond the policy rate. Even as that rate has stayed steady since July, policy has tightened each month with the Fed’s balance-sheet paring, and will tighten more each month until rates fall or runoffs cease. Applying the assumption in the Fed paper cited above, that QT will continue until the ratio of balance-sheet assets to nominal GDP fell to 21%, monetary policy will continue to tighten for at least another year.

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