Quantitative Tightening QT By the Fed What It Is and Economic Effects
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Since the monetary policy changes in 2020, the U.S. economy has been on the upswing, but it has swung too fast. The economic recovery mixed with tightening commodity supplies have led to the highest inflation rates seen in decades. In early 2022, the Fed announced plans to begin increasing its federal funds rate. By June, the central bank had increased its rate to 1.5% and begun the quantitative tightening process yet again.
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By Joshua Rodriguez Date September 30, 2022FEATURED PROMOTION
Every developed nation in the world has a central bank, including the Federal Reserve Bank here in the United States. Central banks have one priority: to maintain a balanced financial system by keeping prices stable and employment rates up. When things aren’t going right economically, central banks turn to interest rates first — the federal funds rate in the U.S. Decreasing the fed funds rate reduces borrowing costs for consumers and businesses, spurring economic growth, but risking inflation. Interest rate hikes increase borrowing costs, pulling cash out of the economy and slowing growth, which could lead to deflation or a recession. When changes to interest rates aren’t enough to create the perfect balance, the Fed uses another weapon in its monetary policy arsenal — quantitative easing and quantitative tightening.You own shares of Apple, Amazon, Tesla. Why not Banksy or Andy Warhol? Their works’ value doesn’t rise and fall with the stock market. And they’re a lot cooler than Jeff Bezos.
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What Is Quantitative Tightening QT
Quantitative tightening is the act of the Federal Reserve shrinking its balance sheet by allowing fixed-income securities it owns to reach maturity. Quantitative tightening, or QT, is also commonly referred to as balance sheet normalization because it happens after quantitative easing has spurred economic growth. With growth in place, the Fed can slowly unwind its excessive asset purchases and get back to normalization, which is why the process is also called unwinding. The Fed’s balance sheet is largely made up of U.S. Treasury securities, mortgage-backed securities, and stocks. It also currently holds corporate bonds after purchasing them for the first time in 2021 to combat the economic effects of COVID-19. However, extra asset holdings on the balance sheet for too long can have damaging effects on the U.S. economy. In particular, maintaining excess liquidity and the low interest rates it tends to accompany for too long can lead to high inflation. Evidence of this fact can be seen everywhere today, from the gas pump to restaurants, grocery stores, and utility bills. So, once economic movement heads in the right direction for long enough, it’s important for the Fed to shed the excess assets it purchased through a quantitative tightening plan.How Quantitative Tightening Works
Quantitative tightening starts when the U.S. Federal Reserve believes financial conditions have improved from recent hardships, and high levels of inflation are on the horizon. In most cases, the Fed has already begun increasing interest rates and is working toward economic normalization following periods of fast-paced growth. To start the QT process, the Fed creates a plan, usually an escalating schedule for allowing the assets it holds to mature. For example, the bank may allow $6 million in government bonds and $4 million in mortgage-backed securities to mature in the first month and $10 million in bonds and $6 million in mortgage-backed maturities to mature in the second month. As the bonds mature, the excess money supply that was created by turning debt into credit — a superpower all central banks possess — disappears. With less money rolling around and interest rates on the rise, consumer spending starts to decrease. As the law of supply and demand suggests, a decrease in consumer spending, or demand, leads to slowing asset price growth. If the Fed moves too quickly with its interest rate hikes or quantitative tightening plan, it could have such a profound effect on demand that the attempt to help the economy could lead to a recession.When the Fed Uses Quantitative Tightening
Quantitative tightening typically takes place when the economy has grown too fast for its own good due to a mix of low interest rates and excessive asset purchases at the Fed. During these times, inflation becomes a serious concern and the central bank is charged with putting growing prices in check. However, it doesn’t happen all at once. The Federal Reserve knows that if it were to pull all the excess funding it injected into the economy out at the same time, it would create an economic disaster. So, it starts with allowing small amounts of fixed-income securities on its balance sheet to mature. Each month or quarter, the amount of debt the Fed allows to mature increases, gradually pulling more and more liquidity from the money supply. The ultimate goal is to wean the economy off what the Fed considers an unnecessary money supply to reduce demand without pain and bring inflation back to its target of 2% without affecting jobs.Example of Quantitative Tightening
When subprime mortgages led to a real estate bubble that popped in 2007, the Great Recession of 2007 and 2008 set in. The Fed came to the rescue in the face of the global financial crisis, spurring economic development by reducing interest rates to nearly zero and taking part in quantitative easing. For the next decade, the Fed pumped money into the economy. Its balance sheet went from just under $900 billion in 2007 to around $4.5 trillion in 2017. That’s $3.6 trillion in the span of 10 years or $360 billion per year. It worked. In 2015, economic conditions were so positive that the Fed started slowly increasing its interest rate in increments of 25 basis points (0.25%). But the real magic didn’t start until 2017. By 2017, the federal funds rate had gradually climbed to about 2.25%. The economy was still doing well and there were no big red flags. So, the Fed decided it was time to move forward with quantitative tightening. It started by letting about $6 billion in Treasurys and $4 billion in mortgage-backed securities mature monthly in 2017. Every quarter, the central bank increased its tightening efforts until it maxed out with the maturity of $30 billion in Treasurys and $20 billion in mortgage-backed securities each month. By 2019, the monetary tightening was done, and as intended, the average consumer was none the wiser. In March 2020, as the Covid-19 pandemic ravaged the global economy, the Federal Reserve stepped in once again. It immediately slashed interest rates back to 0% and announced more quantitative easing. This time, it would purchase corporate bonds, including high-risk corporate bonds for the first time in history.Since the monetary policy changes in 2020, the U.S. economy has been on the upswing, but it has swung too fast. The economic recovery mixed with tightening commodity supplies have led to the highest inflation rates seen in decades. In early 2022, the Fed announced plans to begin increasing its federal funds rate. By June, the central bank had increased its rate to 1.5% and begun the quantitative tightening process yet again.