QT is incrementally improving the transmission of monetary policy by increasing the share of financial assets sensitive to the Fed’s policy rate. Although the policy rate is approaching 5%, trillions of bank deposits continue to offer around 0%. QT strengthens the transmission of policy by mechanically replacing bank deposits with policy rate sensitive Treasuries, and by forcing banks to compete more aggressively for deposit funding. Both outcomes raise the interest rate on assets held by non-Bank investors and will incrementally make risk assets less attractive. This post walks through these two mechanisms and suggests a higher interest rate environment implies a more potent QT.
An ocean of low yielding bank deposits in a higher inflation environment may be impeding the market impact of rate hikes. Deposits are created either through commercial bank credit creation, or indirectly though the actions of the central bank. Non-bank investors have limited control over the aggregate level of bank deposits they hold. A huge QE program and a tremendous bank credit boom forced non-bank investors to hold trillions in low yielding bank deposits. The markedly negative real rates on these deposits suggest their holders are incentivized to rebalance into riskier assets, which eases financial conditions.
QT can dampen this impulse by replacing deposits with Treasuries, which are more sensitive to policy rates. At a high level, QT forces non-bank investors to hold fewer bank deposits and more Treasuries. The deposit rates offered by commercial banks largely depend on factors beyond the Fed’s control, but Treasuries are actively traded and thus sensitive to the policy rate. QT shifts the composition of financial assets towards those that better reflect the Fed’s restrictive stance, in effect raising interest rates for a swath of investors.
Deposits rates are slowly rising to reflect the Fed’s restrictive stance as commercial banks compete for funding. QE left the banking system with a superabundant level of deposits, but there are some signs that competition is heating up. Banks have increased their borrowings from entities such as Federal Home Loan Banks, which are government sponsored enterprises chartered to support bank lending. Loans from FHLBs are more expensive than deposit funding, so at least some banks may be motivated to offer its depositors a bit more interest.
QT should further amplify the competitive process by reducing the aggregate supply of deposit funding. Under Basel III regulations commercial banks are incentivized to rely on deposit funding, which is considered a more stable form of funding. Along with lower interest expense, deposits are an attractive source of funding that is worth competing for. The competitive pressures should heat up as the pace of QT outpaces bank credit creation and gradually shrinks the aggregate level of deposits.
Zero to Four
The Fed’s aggressive hikes have yet to reach the bulk of bank deposits, which is the foundational financial asset for many households. These deeply negative real yields may be extending the portfolio rebalancing impact of QE. Some households have escaped financial repression by moving into Treasury bills or money market funds, but that is not the only refuge. The perceived return of risk assets likely remains high for many, as the memory of the 2021 boom is still fresh.
The Fed cannot force banks to offer depositors higher rates, but QT side steps them and does job by brute force. Every month $60b in deposits yielding around 0% are replaced with $60b in Treasuries yielding around 4%, and deposit rates are also slowly rising. The sizable yield upgrade being forced onto the market may indicate a more impactful QT. When rates were low, Treasuries and deposits were plausible substitutes. But rates are not low any more.
This is exactly right.
I do wonder if the Fed will not declare that we have reached the minimum “ample” reserve threshold until the ONRRP facility drains because thats when the banks have officially raised deposit rates high enough to sufficiently compete with money market funds.
Would love to see more context on the history and research around the ample reserves regime. It seems like a massive change with profound impacts. Are there historical precedents? Did any central banks use this regime before 2008? Did the Fed consider risks and potential downsides to abandoning reserve scarcity?
“ample” reserves is a new beast. prior to 2008, there was a real fed funds market and banks did not need or want excess reserves. The previous system was called a “corridor” system whereas this system is called a “floor” system because the real way monetary policy is conducted now is when the Fed changes the “floor” or the interest they pay on excess reserves (IOER).
New territory. 2018 repo meltdown demonstrated that it will be near impossible to return to a corridor system.
Fascinating observations here.
However, I’m a bit unclear on the mechanics. At the last FOMC presser, Powell said that they are not considering “selling” Treasuries on the open market as part of QT, but are just letting ~$60bn roll off their balance sheet as they mature.
This may be a basic question, but how does this “roll-off” accomplish the mix-shift from deposits to Treasuries? Is it indirect – because the U.S. Treasury will issue new securities to pay back the Fed’s maturing Treasuries (and some of those newly issued Treasuries will be purchased with commercial bank deposits)?
Does it matter if the Treasury pays these off with short-term (T-bills) vs. long-term (Treasuries) issuance? I guess not, since either way those securities have much higher yields than bank deposits.
$60m rolling off the balance sheet has to be absorbed by the private market. A big % of the private market is getting 0%. If you are getting 0% on your deposit, that gives you $60m more reasons to consider moving from 0% to something yielding closer to 4-5%.
Your understanding of QT is correct. Joseph has an article on QT mechanics https://fedguy.com/quantitative-tightening-step-by-step/
Perfect, thank you – this is exactly what I was looking for!
The interesting thing is as passive QT proceeds, my intuition is that the Feds balance sheet becomes more concentrated in longer maturity treasuries. So a passive QT is only putting real pressure on the shorter maturity portion of the yield curve. If on the other hand the Fed actively sold treasuries / MBS to maintain a similar duration profile to private sector holders of treasuries / MBS, how differently would the financial markets be acting?
Do Primary Dealers have a limit as to how much debt their Balance Sheets can handle or can they just keep buying as much as they are told to forever into the future?
You are correct with your intuition. The monthly run-off is capped at $30B for T-bills, $30B for notes & bonds, and $35B for MBS. Only the T-bills bucket is regularly exceeding its cap. The notes & bonds bucket is rolling off only $10B per month most of the time, and occasionally exceeding $30B in some months. The MBS bucket is rolling off only $22B per month. Thus, the longer-maturity securities are rolling off much slower than T-bills. As for your last question, if the Fed sold longer-maturity securities, rates would soar in those maturities. Say hello to 8% mortgages. The Fed would also book a realized loss in those sales because at this point their entire MBS and T-bond portfolio is losing money.
Does anyone, including fedguy have concepts related to MBS negative convexity?
My assumption is, MBS are not easy to sell off, especially at a loss to Fed, however, as Fed holds assets that lose value, how does that work?
Seems like a no win, especially as Fed increases terminal rate, thus increasing their losses.
So this means a greater share of net interest payments from the government are going to households with a higher propensity to consume(?)
What the FED rolls off will be more than offset by new Treasury issuance. The FED was one of the largest investors (perhaps the largest) of Treasuries and US Agencies. As the FED has shown their printing press can dwarf consumer deposits and rescue (cap) Treasury rates.
Why doesn’t the Fed raise their monthly cap and starting sell securities? QT is proceeding at a snail’s pace. A more aggressive QT would tighten monetary conditions by contracting the money supply quicker. Once money is in short supply, rates rise (because rates are the ‘price’ of money). That also drives down asset prices because there’s less money to compete for assets. Banks would need to raise their deposit rates in response as well. And less money means less chance of inflation coming back ala 1970s. $6T of money was created out of thin air during Covid. Raising rates to 5% hasn’t made that money disappear, as you can see by looking at any chart pertaining to money supply or liquidity. And unlike their current strategy, contracting the money supply affects the economy immediately. There is no 1-year lag. They could have stopped inflation by now with a more aggressive QT. Increase the cap to $130B and sell securities… and watch inflation come to a full stop. Powell is not Volker 2.0. The Fed is still too dovish.
Read your question back. The answer is there, between the lines. The truth is, the Fed does not want 2% inflation anytime soon regardless of how many times they publicly state that as their goal. Powell said so himself back in August 2021. They are slow walking their “inflation fight” because they are not fighting it, but rather they are maintaining it, at a higher than normal rate, to make up for a decade of below target inflation.
A higher structural level of inflation (4-6%) is a proven way to get rid of high levels of debt. Now that government deficit spending is a primary driver of the creation of money, the ball is in the government’s court to engineer a higher nominal GDP growth, essentially taking over the role of the central bank.
This nationalization of creating money at some point will have a serious negative effect on the productivity of small to medium size businesses/employers because its demographic cliff will have little incentive to invest outside the umbrella of the treasury welfare state. The corridor of natural price discovery has been captured by vast concentrations of wealth.
How it is even possible to fund massive new CapEx and infrastructure spending, supporting the ballooning cohort of retirees and consumer spending to keep the waste in the economy humming on the edge of an energy cliff, while keeping inflation tamed to 5%?
I believe you’re right; it’s not aggressive or tactical enough to incentivize investment into working hard, re-balancing the extreme bubble of non-productive assets with the value of productive assets.
re: “contracting the money supply affects the economy immediately.”
Touché. And if reserve requirements were still enforced, all Powell had to do was raise reserve ratios.
re: “QT can dampen this impulse by replacing deposits with Treasuries”
With O/N RRPs @ 2023-02-17: 2,059.662 There’s no shortage of cash.
Joseph, I’d love to see a post refuting or acknowledging some of the arguments made by some in the MMT/Post-Keynesian world which are that higher policy rates may contribute to inflationary pressure from increased interest payments. I think this argument is also intrinsically tied to the implication that (especially in the ample reserves framework) a higher fed funds rate doesn’t correlate with higher borrowing costs / deposit rates as well as it used to, and that monetary policy that isn’t tied to reserve scarcity isn’t effective. I personally think the answer to that question is critical since if the Fed can’t even indirectly control credit anymore then it is truly driving blind.
The budget impasse will likely have some unplanned tightening:
“Such swings in bill supply would not only make the securities expensive relative to other instruments like overnight index swaps, but also motivate investors that have access to the Federal Reserve’s overnight reverse repurchase agreement facility to park more cash there.”
Higher IOER in effect is QE , but worse. At least in QE , the Fed was buying bonds in exchange for reserves. Now they are just increasing reserves every time they pay IOER in exchange for a fugazi item called “Deferred Assets”.
With roughly $3 T in reserves , at 5% , the Fed is expanding its reserves by $150 Bn/yr in exchange for effectively nothing.
Frankly the die was cast in 2008. There is no way for the Fed to really tighten policy.
The only tightening will have to come from the fiscal side.
Legal reserves were never a tax. They were “Manna from Heaven.”
Imagine you run a bar and are concerned that the regulars are getting staggering drunk every night and roudy. So you decide you will monitor the price of drinks as an indication of tightness in liquor supply. Well you can do 2 things:
1. Limit the available alcohol and let the regulars bid up the price of the scarce supplies . The bottom line is less liquor is consumed at higher prices. Great.
But – you notice that there are severe alcoholics amongst the regulars and limiting the liquor supply means you have to call the ambulance a few times each night to deal with DTs.
So. You have a Bernanke-eske idea.
2. You issue free coupons good for liquor purchase to the regulars . Now , with the extra money , the price of liquor can be raised. Problem is – you have not addressed the underlying problem have you?
So in both cases , if you are outside , simply monitoring the price of liquor ( FFR) you might conclude that (2) is doing the job – and then you are surprised that the drunken brawls are continuing.
90% ish of mortgages in the US are longer term fixed rate. Mostly struck around 3.5%. Thee folks are not feeling any pain – other than they cant sell the house ( they will have to payoff a mortgage worth 50 cents on the Dollar .. at par).
A large % of the pop is employed by the govt or relying of soc security. Those things are indexed to inflation. Soc Sec saw a 8.7% increase for 2023.
The RRP is putting a nice chunk of change in the pockets of savers.(MMF).
The govt will run a large fiscal deficit and the Fed will feel pressure to support the accompanying bond issuances. So aggressive QT is out.
So – no wonder financial conditions are looser now, after 450 bp of “rate increases”.