The 2 Trillion Reasons Why Fed Tightening Isn't So Scary

Stubborn inflation means more interest-rate increases are coming from the Federal Reserve and that sounds like great news for banks. They’ve already been reporting booming net interest income: At JPMorgan Chase & Co., it was up 28% in 2022 and for Bank of America Corp., 22%.

But there are downsides to the Fed’s tighter monetary policy too, and those have bank executives and many investors fretting: The reversal of its bond-buying program and the shrinking of the central bank’s balance sheet, which will suck money out of the financial system and put pressure on markets and banks’ funding.

The Fed flooded the economy with cash through quantitative easing during the Covid-19 pandemic. Some investors believe that drove up the value of risky assets, although the relationship is far from exact. The Fed created trillions of dollars of central bank reserves, which it used to buy bonds via banks, creating trillions in deposits. Total US bank deposits grew by $5 trillion between the end of 2019 and the April 2022 peak. Keith Horowitz, banking analyst at Citigroup Inc., estimates about $4 trillion of that was created by the Fed’s policies.

Now, QE is going into reverse – becoming quantitative tightening – and banks are worried their deposit base will shrink. As the Fed lets its bond holdings run down – currently to the tune of $95 billion per month – central bank reserves will be pulled from the banking system and to some degree deposits will disappear.

And for investors who think the growth in reserves drove stock markets higher, the promise of shrinking reserves is giving them the jitters. The Fed has already shrunk its balance sheet by $480 billion in the past eight months, coinciding with a rough ride for financial assets of all kinds. Total bank deposits have shrunk by a similar amount, but their holdings of reserves have fallen by even more.