Interest rate moves aren’t the only tool in the Federal Reserve’s kit

The Fed is slowing the pace of shrinking its bond holdings, aka quantitative tightening, perhaps before easing its interest rate stance.

For about two years now, the Federal Reserve has tried to cool inflation by setting interest rates high and keeping them there. But while the federal funds rate may be the most famous tool in the Fed’s monetary policy toolkit, it’s not the only one.

Also for about two years now, the Fed has been involved in something called quantitative tightening: letting trillions of dollars’ worth of mortgage-backed securities and government debt run off its balance sheet.

Quantitative tightening, or QT as the cool kids call it, also helped push interest rates higher and inflation lower. So now that Chair Jay Powell is considering a rate cut come September, is it time to put QT back in the toolbox too?

When the pandemic hit, the Fed dusted off its emergency playbook from the 2008 financial crisis and found the Ben Bernanke Hail Mary strategy: Buy a ton of government bonds and mortgage-backed securities to keep the economy afloat.

“So, we went from $4 trillion to $9 trillion. We more than doubled the [Fed’s] balance sheet in response to the pandemic,” said Olu Sonola, U.S. head of economic research at Fitch Ratings.

That was quantitative easing, and it worked. Maybe too well.

By 2022, with inflation roaring, the Fed started quantitative tightening: allowing up to $60 billion a month in Treasury bonds to roll off that balance sheet.

“As they offload those Treasury assets into the market, they’re putting downward pressure on prices,” Sonola said.

And upward pressure on interest rates on everything from mortgages to auto loans.

Fast-forward to the summer of 2024, and the Fed is still tightening quantitatively, even though it seems like it may want interest rates to come down soon.

“So, it’s counterintuitive. It seems like it’s going in opposite directions,” said Tiffany Wilding, an economist at Pimco, a large bond investment firm.

But Wilding said the Fed’s shrinking balance sheet isn’t necessary undermining an effort to relax financial conditions. It’s just another step the Fed is taking to normalize monetary policy.

“A continued reduction in the central bank’s balance sheet, the Federal Reserve also believes is returning the balance sheet towards neutral,” Wilding said.

The Fed has slowed the pace of quantitative tightening this year. But Matthew Luzzetti at Deutsche Bank said that for now, there’s another reason the Fed hasn’t stopped shedding bonds completely.

“The smaller the balance sheet is today, the more scope they might have to respond to a shock or a crisis in the future,” Luzzetti said.

Not to get us worried or anything.