personal views of a former fed trader

Quantitative Tightening Step-by-Step

This post describes the mechanics behind quantitative tightening (“QT”) and reviews the prior QT experience. In our two-tiered monetary system, it is helpful to view QT through a framework that takes into account the perspectives of Banks (those who have a Fed account) and Non-Banks (those who don’t have a Fed account). Mechanically, QT reduces the level of cash held by Banks (reserves) and changes the composition of money held by Non-Banks (more Treasuries and fewer bank deposits). The Fed is unsure how low Bank reserve levels can fall before impacting the financial system, so it executes QT at a measured monthly pace. The prior QT experiment began in late 2017 and ended in September 2019, when a sudden spike in repo rates panicked the Fed into restarting quantitative easing.

QT Mechanics

Quantitative Tightening is when the Fed receives principal repayments from its Treasury holdings but does not roll them over into newly issued Treasuries. Instead, the Fed takes the proceeds and simply extinguishes them. The reserves disappear from the banking system with a few keyboard strokes just as they appeared with a few strokes during QE. The mechanical impact of these actions can be described through the eyes of the Fed, Treasury, Banks, and Non-Banks.

Fed: QT shrinks the Fed’s balance sheet. The Treasury security asset is repaid with the repayment extinguishing the Reserves liabilities created to purchase the Treasury in the first place. The QE transaction is reversed (see here for a QE Step-By-Step piece).

Treasury: Nothing changes except the ownership of Treasuries issued. Fed owns fewer Treasuries while Non-Banks own more. Note that the Treasury may alter its issuance patters during QT – such as issuing more short-term debt since longer dated debt may become more expensive in the absence of QE. QT can thus indirectly impact curve shape.

Banks: QT shrinks the collective balance sheet of banks by reducing their reserve assets and deposit liabilities. (Note that Banks can also purchase Treasuries, in which case they would simply swap reserve assets for Treasury securities).

Non-Banks: Non banks essentially swap one form of money (bank deposits) for another (Treasuries). But the two types of money are not perfectly substitutable: Treasuries are free of credit risk and offer some return, while bank deposits come with some credit risk and no return.

QT effectively increases the supply of Treasuries to the private sector in addition to new supply from ongoing deficits.

Fed (Mostly) Sets the Pace

The Fed proceeds cautiously with QT because it does not know how QT will affect the financial system. Specifically, the Fed is reducing bank reserve balances without knowing the minimum level of reserves balances the financial system requires to function. In the past, the Fed began with a slow monthly pace of $6b a month of Treasuries that ramped up to $30b a month. It then slowed the pace in mid 2019 with the thought of ending QT in late 2019. Note the maximum amount of QT the Fed can conduct each month is limited by the amount of maturing principal it receives that month. The amount maturing varies significantly each month and is largely a function of past policy choices.

Fed controls how quickly QT proceeds. Source: July 2019 Monetary Policy Report.

Maturing principal that is in excess of the QT pace is rolled over at auction. For example: if the Fed receives $20b in maturing principal but is capping the pace of QT at $15b a month, then it will rollover $5b into next auction. The $5b will be rolled over in proportion to the offering sizes being auctioned. For example: if $40b of 3-year and $60b of 10-year were being offered, then $2b would be rolled into the 3-year (40%) and $3b would be rolled into the 10-year (60%). (For detailed rollover mechanics see here).

Minimum Required Reserve Levels

QT gradually drained bank reserve balances (and the RRP) until it was ended late 2019 after a sudden spike in repo rates. The Fed frequently surveyed banks throughout QT to gauge their minimum level of required reserves. Banks widely reported that they had a lot more reserves than they needed. A rough estimate based on the surveys suggested that the banking system as a whole needed about $600b in reserves, which implied that QT could’ve continued all to way to 2021.

QT gradually drained reserve balances from banks and the RRP

In September 2019 repo rates exploded higher and panicked the Fed into thinking that QT had broken the market. Some policy makers viewed the spike as evidence that the level of reserve balances in the banking system had hit a minimum. The Fed promptly began to both lend in the repo market and restart QE in an effort to add reserves into the system. The repo market quickly stabilized, but it was difficult to tell if the spike was actually caused by an insufficient level of reserve balances. In any case, the repo spike marked the end of the Fed’s QT experiment.

Repo rates exploded higher in September 2019

32 Comments

  1. Mike S

    I think you’ve written about how the Fed can’t tackle the current inflation issues (more fiscal related today and supply side). You commented in the older post about the mechanics of QE “QE is more about changing the composition of money – fewer Treasuries, more bank deposits – than the quantity. The impact of that is lower interest rates, which pushes investors into riskier assets (the ‘portfolio rebalancing’ effect). Thus QE pushes asset prices higher, rather than the prices of goods and services, which is what indexes like CPI measure.” So I’d take it you continue to believe that with QT the Fed will not be able to reduce inflation. To what extent do you think we see investor inflation expecations react to a more aggresive taper, even if the plumbing suggests minimal impact on near term realized inflation?

    • Albrey

      There are 2 types of QE: QE that recapitalizes banks (think 2008), and QE that goes to the public as stimulus. The QE we experienced in 2020 was the latter, which is showing up in the prices of goods.

      That said, typically the Fed raises interest rates to create deflation. While they’ve done that in the past, it’s yet to be seen whether they’ll make meaningful adjustments over the next year. IMHO we’ll continue to see price inflation over the next couple of years. The Fed cares more about inflating debt away than dealing with a recession.

      • Thomas

        “inflating debt away”
        Why do we have to inflate the debt away?
        To create money in this current system, someone has to borrow and create debt.
        No debt = no money.
        The safest borrower is the state as a monopolist issuer of the currency. It’s safer for the government to borrow because they can’t go bankrupt while individuals and corporations can go bankrupt. If no one borrowed at all there would be immediate deflationary collapse because there would be no money.

      • Aryeh Liwschitz

        The Fed does not raise rates to “create deflation” The Fed. Raises rates to lower the pace of inflation. – two very different things that have very different outcomes. Disinflation Deflation.

  2. Dot

    Is the repo market vulnerable or did they fix that? Would be good not to have that interfere with the right policy going forward.

  3. John Ahearn

    They need to consider that the spike in 2019 was shadow bank institutions having trouble rolling their rehypothicated treasury positions as banks started getting particular about who was their counterparty in ON and TERM repo.

    There was still liquidity, it was credit risk that was the concern. The game only works if there is so much liquidity and such low rates that any dog shit borrower can handle the carry costs and no one is concerned about exactly how levered that cusip is.

    • Martin Clennon

      John, i am trying to understand how rehypothecation works within the context of the us banking system. I did a little research and found that when a treasury is loaned to the treasury it actually changes ownership to the borrower so how does rehypothecate happen? I am lost and hoping I can find someone who can explain.

  4. Yash Agarwal

    IPS JULY 3.5 SELL, YOLO

  5. Bill

    Thank you! I appreciate the clarity, here.

  6. Patricia Trudgeon

    Thanks for another very informative article. The Fed really doesn’t have a clue about money because most of it happens outside the US (Euro$, derivatives and forex) and the Fed isn’t involved in it. They gave up understanding money a long time ago. Fed is reactive to events like the repo spike in Sep 2019. Although they haven’t got a clue, they tell the world QT must be responsible and adjust data to their narrative. All the Fed can do is managing expectations in the belief they are right. They always wrong. It’s like a magic show gone wrong.

  7. Shane Martinez

    I guess you were right about the Fed crashing the market with interest rates.

    Is the Fed worried about an inflationary spiral? What metrics would do you think the Fed is tracking to monitor the amount of inflation growth? Do you personally think the inflation growth is bad enough to warrant accelerating rate hikes and if so should we all sell out of our portfolios or do you think inflation will subside?

  8. Ivan Vesely

    Jeff Snider keeps repeating that “the Fed doesn’t know money.” While I have my reservations, your article could be read similarly. As if the only thing they know are reserves and if there are problems in repo it must be because the system needs more of them.

  9. Dan S

    Joseph,
    Thanks for article – always appreciate the T-accounts. Regarding the Fed’s balance sheet entry on liability side, the “-100 reserves” could be more specifically stated as “-100 TGA”. Similarly, the two entries on the asset of the Treasury’s balance sheet could be +100 and – 100 to the TGA. Is this correct?

    I know you are simplifying the terms for reader clarity, but wanted to confirm since sometimes we’ve used “reserves” to only refer to those reserves at Fed held by Banks (and TGA to refer to deposits held by the Treasury at the Fed). Thank you for any clarifications!

    • braesikalla

      The TGA is a Fed account and as such it can only hold reserves. When the TGA instructs payments for the Treasury to the private sector, it transfers reserves to banks, and the banks generate deposits of the same amount.

      • rsm

        Then banks put the reserves in RRP to get the MMMFs a return of 5 bp, when they might keep that $1.6 trillion in RRP and get 9 bp (0.15 IOR minus 0.06 interest on MMMF cash)?

        Or are both banks and money market funds, etc. making far more than 15 bp shorting Treasuries borrowed through RRP?

        • Karl

          My understanding is that the banks won’t take the MMMF cash even at 0% because of the capital required and the return available on that capital. The Fed offers RRP to the MMMF so that the effective funds rate stays above zero, ie their declared floor.

        • rsm

          Karl, but where is the money market fund cash before it goes into RRP? Is it held by banks? Are banks telling these cash pools, “better put your cash in RRP, we don’t want to hold it because 15 bp IOR is too little”?

  10. Kevin

    judging from Fed’s current bond holdings monthly maturity profile, Fed probably can’t afford to QT more than $ 40 billion per month at maximum.

  11. Systematic Macro

    Hello –
    First, thank you for your blog !
    In this post, you write: “QT effectively increases the supply of Treasuries to the private sector in addition to new supply from ongoing deficits.”
    I am not sure I see how QT increases the supply of Treasuries to the PS ?
    I would agree that, if the Treasury keeps its issuances, the absence of QE increases the supply of Treasuries, because you get rid off a strong buyer force, but how come QT is actually increasing supply ??

    • Joseph Wang

      If you hold the Treasury outstanding constant (no gov deficit), then when a Treasury matures it will have to be rolled over. When the Fed is doing QT then Treasury must find someone in the private sector to take the Fed’s place during the roll over. So supply to private sector increases.

  12. James BT

    Thanks for a great blog and slightly to my surprise, a really interesting and accessible website. I liked your dual money type analogy which I found helpful. Similarly I’ve enjoyed the T accounts above.
    When it comes to a CB’s own Reserves, where the money is created and destroyed, you use the term ‘Reserves’ in the Reserves T account, just as you do for a regular clearing bank but I’m not sure who the counterparts is. If I understand all this correctly, a synonym for the Credit side of the CB Reserve T account would be Trust, with the counter party being society/currency owners? Is that right?

  13. jetx

    Hahaha. Sometimes it’s all a pile of jargon. Remember US print their own money, produces it to the point that tooooooooooo much has been given to a selected few (only), and will never ever intended to alleviate a common people’s problem. The system is created that way to control the inflation. If you can afford something in demand with no effort what would think will happen to the price of that item that you can afford so easily back then? Yep, all prices are in the ceiling now. Now make it a bit worst, what if US currency is already on its down trend, shifting away to…. (i cant say) it will just keep losing its value which is not even pegged on gold for a long long long time. Reach remains rich and have access and bailout upon calling a fake “bankruptcy” vs the common people living on daily pay, which cant even afford a “rightful dignified” health benefits.

    In short, they want you to value it, use it, be in debt with it, and they wont produce much so you keep wanting it and work for it, basically spend it only on your basic need just enough to make business model move but low enough so as not to raise the demand for goods.

  14. B

    Just to be clear, when you say this:

    “Fed: QT shrinks the Fed’s balance sheet. The Treasury security asset is repaid with the repayment extinguishing the Reserves liabilities created to purchase the Treasury in the first place. The QE transaction is reversed”…….

    This isn’t actually extinguishing the Reserve liabilities from the Treasury Seller’s account, but rather US Treasury’s account, right?

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