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.