Come Hell or High Water

Published on January 23, 2023 by Free

Governor Waller suggests two significant changes to the Fed’s QT framework that effectively removes all obstacles to an extended QT. First, Waller suggests that the $2t in RRP balances should be consolidated with bank reserves when thinking of bank liquidity levels. This indicates that the Fed would be comfortable with bank reserve levels dropping below the roughly estimated $2.5t minimum level. Second, Waller appears to be open to maintaining QT even if policy rates are cut. This would reverse longstanding Fed dogma where both the policy rate and balance sheet must express the same stance of monetary policy. This post reviews these two developments and suggests that they represent an effort to re-tighten financial conditions by steepening the curve.

RRP Balances Are Reserves

The Fed appears to have redefined their criteria for minimum banking sector liquidity in a way that enables QT to continue for years. QT withdraws liquidity out of the financial system, but in ways that the Fed is not able to control. The liquidity can come out of the banking sector (bank reserves), or it can come out of the RRP (RRP balances). So far, QT has largely drained liquidity out of the banking sector. This presents a problem to the Fed, who seeks to continue QT and also keep bank reserves levels above ~$2.5t. Reserve levels are around $3t today and on track to fall below the estimated minimal level by end 2023.

Waller’s framework implies excess banking sector liquidity of around $2.5t

Waller now suggests that he views RRP balances to be fungible to bank reserves. He suggests banks who need liquidity can simply raise deposit rates to attract money out of the RRP. Under this framework, banking sector liquidity for QT purposes is over $5t ($3t reserves plus $2t RRP balances). Waller also suggests that QT would be tapered when banking sector liquidity is around 10% of GDP. With the actual QT run rate around $75b per month, QT could continue for three more years under this change.

Note that this change will likely have very limited impact on money markets, as the actual liquidity needs by banks is likely far lower than the Fed’s estimate.

Thou Must Be Consistent

Waller indicates that he is open to conducting QT while also cutting rates. A longstanding tenant of Fed dogma has been that the policy rate and balance sheet policy must express the same stance of monetary policy. This means QE can only occur when the Fed is in rate cutting mode, and QT can only occur when the Fed is in hiking mode. This constraint is self-imposed and appears to stem from the difficulty in communicating what would appear to be contradicting signals – the Fed both stepping on the gas and brakes at the same time.

Macro Musings July 2022 podcast with Governor Quarles and David Beckworth

The dogma of consistency likely contributed to a policy error in 2021 and may need relaxing. Former Fed Governor Quarles has suggested that the constraint kept the Fed from hiking rates in 2021 when it was obvious inflation was becoming a problem. In the same way, the need for consistency would keep the balance sheet much larger than needed should the Fed decide to cut rates in the coming months. The BOE has already demonstrated through its emergency purchases that it is possible to separate the balance sheet and policy rate. The Fed should also be able to do the same.


The Fed’s new guidance is likely an attempt to retighten financial conditions amidst the recent bout of rapid loosening. Market participants appear to believe that rate cuts are imminent, which in turn have led to lower mortgage rates, a weaker dollar and higher asset prices. This increases the probability of a second bout of inflation, an issue in the 1970s that the Fed is keen to avoid. In the absence of firm forward guidance, the Fed’s obvious tool to retighten financial conditions would be through its balance sheet.

Financial conditions have been loosening rapidly

In practice, the policy rate and balance sheet policy likely operate on different channels with different impacts on the real and financial economy. The experience across countries over the past decade suggests QE has limited impact on the real economy, but significant impact on the financial economy. Should QT continue amidst rate cuts and low policy rates, we may find out if the reverse is also true. That would be precisely the type of tightening the Fed is looking for.

27 comments On Come Hell or High Water

  • Sorry but I am a bit confused by the last sentence: Do you mean 1) ‘Fed is looking for tightening via QT impacting the financial economy’? , or 2) ‘Fed is looking for tightening via QT impacting the real economy’?

    • Fed cuts rates and does QT simulatenously. By doing so, they hope to support the real economy while curbing the finacial economy. Practical implications: reduced rates but also reduced access to credit.

    • I believe Fed is looking to tame the unruly financial economy

  • With regards to “Should QT continue amidst rate cuts and low policy rates, we may find out if the reverse is also true”
    – If the real economy is good, there is no EPS compression, why wouldn’t the financial economy

  • What was the reason that the fed made an increase in liquidity swaps in January 2022? Were there liquidity problems? were dollars missing? at that time the stock market was at its highest.

  • There is also the issue that the Fed’s balance sheet has been growing in size ever since the GFC. QE that is never unwound is simply defacto monetization of government debt. If the Feds balance sheet keeps on growing in size with respect to the economy, at some point folks will start questioning the Fed’s independence. There is also reason to doubt whether the interest rates o long term government debt are in fact market determined as opposed to determined by central bankers.

  • One could justify rate cuts with QT when the FFR target range is likely well above the nominal neutral rate, which appears to be the case.

    If Target_FFR > Neutral_FFR policy is still tight so continuing QT seems much more reasonable.

  • Hi! What about the tightening that is going on in the banking sector, as measured by the “Net Percentage of Domestic Banks Tightening Standards for Commercial and Industrial Loans to Large and Middle-Market Firms”, for example. Doesn’t that work as a stronger drag on the economy, and therefore on financial liquidity?

  • Would it be fair to say that they are neutralizing QT using TGA and RRP at the moment in a wait and see approach as to what inflation will do? Surely if assets drop hard and they are forced to intervene all plans for balance sheet reduction go to the waste bin.

  • Isn’t the effect of raising rates and qt the same in the end? Decreased access to credit = Decreased inflation and growth?

  • Joseph—wow this would lead to a re-steepening in a very direct fashion in a reverse YCC in which the FED pushes the duration higher—-am I missing something?

    • I think that’s what would happen – I imagine that extra 2+ trillion in duration supply from QT would have a big impact, especially if economic conditions turn out better than expected.

  • Interest rates are just a reflection of the cost of money resulting from the simple mechanism of supply and demand. There’s a reason why the official discount rate is not matching up with the market’s bond rate. Time and time again will review that central planning cannot control prices but only supply.

  • Thank you for this one. This is very helpful. As a kind of a side note – Joseph, do you believe that the current market consensus that is pricing in early rate cuts 2023/2024 will happen to be eventually incorrect i.e. wrong? Like it’s a kind of a game FED plays with the markets now: claiming they will keep the rates higher for longer to tighten financial conditions but they will eventually start cutting the rates down in 2023 which will prove the market right at the very end? I would be happy to hear your personal opinion on this (understanding that this is speculation and the actual rates game play will depend on GDP growth and soft-landing / mild recession / hard recession actually materialising).

  • For the very long-term…..the Social Security trust fund is going to be bust in less than 15 years (at the max).

    Fair guess that Social Security spending is going to get monetized. Who knows if the Fed is even thinking about this—-but (arguably) best to clear the balance sheet now to prepare for a future of (arguably) permanent monetization of spending.

  • I think the interpretation that RRP is “fungible” to bank reserves is too strong. They certainly are interchangeable from a macro point of view when talking about liquidity in the financial system. However, as you rightly point out, the constraint comes from the reserves. So the Fed will run into a problem if QT mainly affects reserves and leaves large sums in the RRP.

    Governor Waller is right, of course, to point out that it’s the banks’ responsibility to compete for this liquidity by offering more attractive interest rates on deposits. So the Fed does not have a huge incentive to wade into this debate at this stage. But given the complications posed by the debt ceiling fight, it’s not unlikely that they might be forced to take a more proactive stance sometime in the summer (maybe as early as May) – my guess is they lower the counterparty limit in the RRP at some opportune moment to the lower takeup that we will likely see in the coming months. This is to prevent a resurgence when the X-date approaches and Treasury has to once again reduce the outstanding Bill amount.

  • I am at a loss as to why a combination of reduced RRP causes a steepening of the yield curve? Can you please explain that?

    Thank you as always for your inspired work.

  • Joseph. If there was no RRP facility, the RRP balances would be reserves right? In my mind, the RRP temporarily pulls reserves out of the system. Is this correct?

  • The FRB’s +8 Trillion of Investment Securities holdings plus the $2.0 Trillion of RRP is almost 50% of annual GDP; and validate the FRB printing press engine room is running too hot, with the lights are on, and the doors are locked.

  • re: “open to conducting QT while also cutting rates”

    How does the FED cut the O/N RRP award rate without unleashing a tsunami?

    The FED is operating the economy in reverse. Interest is the price of credit. The price of money is the reciprocal of the price level. The money stock can never be properly managed by any attempt to control the cost of credit.

    • “Waller indicates that he is open to conducting QT while also cutting rates.” Like I advised. That’s the 1966 Interest Rate Adjustment Act.

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