The Fed Will Slow QT. What Matters Is Where It Stops

With interest-rate cuts off the table for now, the US Federal Reserve will focus on a different topic at next week’s policy-making meeting: when and how to slow quantitative tightening, the process of reducing the vast securities portfolio amassed in previous efforts to support economic activity.

A final plan should be in place by the middle of this year. Whatever happens, the destination matters a lot more than the speed.

The Fed’s securities holdings affect the amount of cash available in the economy. The central bank’s purchases put money into people’s bank accounts, which the banks then hold in the form of excess reserves. When reserves are abundant, money market rates are stable, underpinned by the interest rate the Fed pays on reserves. When reserves become too scarce — as they did in September 2019 — banks scramble for cash and money market rates climb and become volatile.

Problem is, nobody knows exactly at what the level reserves become scarce. Finding it will be like landing a plane with an imprecise altimeter. For this reason, the Fed needs to flatten out its rate of descent as it nears the runway and be extra careful around the point of touchdown.

Right now, there’s still plenty of room for maneuver. Reserves stand at about $3.6 trillion, compared with less than $1.5 trillion in September 2019. Since late 2022, though, they’ve been supported by nearly $2 trillion in outflows from the Fed’s reverse repo facility, set up as a place for non-banks such as money-market mutual funds to park their cash. With only $445 billion remaining in the facility, that supply of reserves will soon end, and reductions in the Fed’s securities holdings will affect reserves more directly.

Awash in Cash