ABOUT THE AUTHOR
A member of Putnam's Fixed Income team since 2007, Onsel Gulbiten analyzes macroeconomic issues, including inflation, interest rates, and policy developments.
How long will the Federal Reserve continue quantitative tightening (QT)? How large will its balance sheet be when QT ends? These important questions impact financial market liquidity, the anchor of asset values. We assess the likely path of QT in the years ahead.
- The Fed is continuing QT to reduce its large balance sheet, which is currently about twice as large as it was before the Covid pandemic.
- The Fed will try to avoid a market disruption like the money market disfunction and rate spike that occurred in September 2019.
- The composition of the Fed's balance sheet is likely to be a constraint on QT.
Falling bank reserves could disrupt markets
As the Fed pursues QT, it will monitor bank reserve scarcity. When the Fed first started quantitative easing (QE) in 2008, it had initiated an ample reserve system and began paying banks interest on reserves sitting on the Fed's balance sheet. The interest rate on reserves (IOR or IOER) typically acts as the ceiling of the Fed's target policy rate range for federal funds. In order to make sure that short-term rates stay in the desired range, the Fed has another facility, its overnight reverse repo (ON RRP) window, through which the Fed pays interest on overnight deposits. ON RRP is lower than IOR and helps the policy rate stay in the target range.
When bank reserves are abundant, the policy rate stays comfortably in the range. When reserves become scarce, the federal funds rate rises beyond the target range, and disruptions can happen in other money markets.