Many people are talking about ‘quantitative tightening’ and ‘balance sheet reduction’, and some people are blaming it for market volatility, discussed here, here, here. IMHO, blaming balance sheet reduction for market volatility is cargo cult mumbo jumbo.
What is QT? During the crisis, a lot of bad loans were made and a lot of risky bonds got issued. When the market had its Minsky moment in 2008, everybody simultaneously realized they had too many risky assets and needed to adjust portfolios. When everyone tried to sell at once, prices overcorrected. Worse, there was the risk of a debt-deflation spiral, where the financial crisis tanks the economy, making even more mortgages and bonds unsound, in turn further worsening the crisis and tanking the economy.
Driving base rates to zero seemed inadequate to the task of restoring equilibrium. So the Fed stepped in with quantitative easing: buying the securities no one else wanted to own, taking toxic assets off of private sector balance sheets onto its own balance sheet. Effectively out of the system.
By pegging overnight rates at 0, committing to keeping them at 0 for an extended period, and buying at the long end, the Fed was expanding the zero interest rate policy (ZIRP) down the yield curve.
Today, when the Fed has stopped doing QE, every day the portfolio on the balance sheet shortens by a day, and some of it rolls off of the short end.
When a bond on the Fed’s balance sheet matures, it’s (sort of) the reverse of QE, so some people call it quantitative tightening. (A more exact opposite of QE would be selling long-term securities into the market.) The maturity is a forced sale of an overnight obligation. The maturing bond used to be a long-term instrument, but now it has rolled down the yield curve so it’s short-term. The Fed gets cash, the bond obligation is canceled.
It’s a little like when a bond matures in your brokerage account, broker calls and ask what you want to do.
Maybe you say, roll it into a T-bill or money market fund, which is the most neutral thing to do.
Technically, when the bond matured, it changed your positioning.
But the maturity didn’t constrain your position at any time, you could offset it any way you wanted, you could sell it, swap it. Rolling into another short-term position would be the most neutral action.
It’s the same for the Fed. In the Fed’s case the maturity drained liquidity. The market lost a cash asset when it paid off the bond, and lost a corresponding cash obligation when the bond was paid off.
The maturity reduces the Fed’s balance sheet. But doesn’t constrain monetary policy in any way. The Fed pegs base rates like Fed Funds. Every day it can add or drain liquidity to keep short rates close to target.
So, to sum up: QT is like a scheduled sale of a short-term security.
And short rates are pegged.
So QT doesn’t affect short rates. The Fed will do whatever is necessary to maintain the peg, including adding liquidity to offset any drain from QT.
And QT doesn’t really affect long rates.1
Monetary policy affects the market and the economy through interest rates, which tell you everything you need to know about liquidity and expectations. How else would it work? If it’s not impacting rates, it’s not impacting policy, the economy, the stock market.
So why are people hand-wringing about QT? It’s nonsense. Voodoo economics.
What do QT hand-wringers want the Fed to do, not let the drain happen at the short end of the curve? Indeed, the Fed doesn’t necessarily drain, because they peg the short end of the curve. They will end up buying back whatever is needed to maintain the peg, adding liquidity.
And there are $1.5t in excess reserves, and via interest on excess reserves, any bank can increase or reduce deposits to the Fed at a fixed rate. If the Fed does nothing to offset the drain when a bond matures, all that happens is excess reserves get drawn down. (Bank customer who issued the bond instructs the bank to pay the Fed. Bank instructs the Fed to debit their excess reserve account at the Fed. Deposits go down, excess reserves go down.)
A (partially valid2) criticism of QE was that if the Fed adds liquidity, but people just park it back at the Fed in the form of excess reserves, it doesn’t impact the real economy. The same applies when the process is reversed. If the Fed drains liquidity, but people just draw down their excess reserves, it doesn’t impact the real economy.
Do QT hand-wringers want the Fed to buy at the long end? That’s ridiculous, the yield curve is flat. It would be nutty to be tightening and simultaneously doing QE.
Do the QT hand-wringers think Fed tightened too much and should ease? There they may have a point, but that has absolutely nothing to do with balance sheet reduction and QT per se. For any given tightening posture, it’s essentially a technical matter whether the Fed implements it by automatically rolling stuff off the short end of the balance sheet, or automatic adjustments via excess reserves and IOER, or discretionary open market operations at the short end.
The Fed statement responding to market concerns about the balance sheet reduction and QT seemed a little like telling the market ‘oh yes dear, anything you say’ but just doing same thing they’ve been doing all along.
It seems like some board members thought they had to say something but there’s nothing to say, so they’re like ‘ok fine whatever’.
I think Timaraos in WSJ and Duy on Bloomberg are on the money. There are always talking heads blaming something for market gyrations. If it’s not QT, then it’s ETFs, risk parity, algos. It’s just mumbo jumbo to explain movements that are pretty stochastic. And QT is not really a thing, except to the extent that a technical side effect of policy normalization is balance sheet reduction.
The worst part is, a lot of the QT hand-wringers are free market fetishists who were probably complaining about QE in the first place. They sure seem to think the market is pretty effing fragile… OMG QE! OMG QT! Algos! Risk parity! ETFs! They are are messing with the function of the free market! If the market has a cow and can’t deal with this crap and has a crisis every 10 years, maybe it’s not all it’s cracked up to be.
I believe in complementarity, the idea that you can’t necessarily have one deep consistent model of reality, possibly the best you can do is many shallow models that are applicable in overlapping circumstances.
But it’s still pretty impressive that markets work as well as they do most of the time, when so many people are mostly applying simplistic heuristics that don’t reflect underlying reality.
I could write a series a la Penn Jillette’s “Bullshit!” and go all Lewis Black/Andy Rooney on why easing does not cause deflation, there is no such thing as a chronic safe asset shortage, and MMT is not really a new thing.
But I won’t. Just stay off my lawn!
1Suppose the bond that matures is a 10-year, and the issuer floats a new 10-year. If you have a lot of new issuance, that would pressure long rates. Hence the policy of allowing at most $50b per month to mature without replacing it at the long end. </p>
2QE pushed rates down at the long end. By pegging overnight rates at 0, committing to keeping them at 0 for an extended period, and buying at the long end, the Fed was pushing ZIRP down the yield curve. QT doesn’t directly impact rates at the long end, although maturing bonds maybe be refunded with new issuance. Given that the yield curve is flat, and credit spreads pretty normal, seems like no big deal. </small>