Assessing the recent quantitative tightening

The impact of shrinking central bank balance sheets

In this paper, Du et al. provide a comprehensive assessment of the impact of quantitative tightening (QT) on financial markets and economies in seven countries, namely Australia, Canada, Euro area, New Zealand, Sweden, UK, and US. Their main findings include:

• Asymmetry Between QE and QT: The authors find that the effects of QT are asymmetric compared to those of quantitative easing (QE). While QE has pronounced effects on government bond yields and financial conditions, the effects of QT are smaller and less impactful in absolute terms.
• Impact on Government Bond Yields: QT announcements are associated with a small increase in government bond yields, typically by 4-8 basis points at horizons of one year and longer. This suggests that QT has more of an impact than “paint drying,” but far less than simply reversing the effects of QE.
• Yield Curve and Policy Rate Signals: QT announcements lead to a steepening of the yield curve and may signal a greater commitment to raising policy interest rates. However, the effects on most other financial market indicators are limited and often statistically insignificant.
• Active vs. Passive QT: The implementation of active QT (selling bonds) has a larger impact than passive QT (allowing bonds to mature without reinvestment), particularly on longer maturities.
• Overnight Funding Spreads and Convenience Yield: QT has been associated with a modest rise in overnight funding spreads and a decline in the “convenience yield” of government bonds. However, QT transactions did not significantly affect the pricing and market liquidity of government debt securities.
• Flow of Funds During QT: As central banks reduce their holdings, domestic nonbanks have largely stepped in to compensate for the reduced bond holdings by central banks. This shift in investor behavior suggests that nonbank domestic investors play a crucial role in absorbing the changes in central bank holdings during QT.
• Investor Behavior and Demand for Government Debt: Du et al. evaluate how QT affects investor behavior and find that “households” (including hedge funds) in the U.S. have been particularly important in replacing the Fed’s security unwind during QT. The behavior of other investor types during QT is heterogeneous across economies.

The authors note several caveats to their analysis: The relationships observed may not apply during standard recoveries or periods of slow growth. The number of observations for much of the analysis is limited, and there is substantial heterogeneity across country experiences. Additionally, the estimates of the announcement and implementation effects of QT could understate any impact if markets incorporated these changes before the narrow dates used for analysis.  While QT has been smooth to date, the authors caution that frictions could increase in the future, potentially leading to sharper movements in financial markets, similar to the moment when water suddenly boils.

Quantitative Tightening Around the Globe: What Have We Learned?
Authors: Wenxin Du, Kristin J. Forbes, Matthew Luzzetti
From: Columbia University, Massachusetts Institute of Technology, Deutsche Bank

Comments on some of the findings

Christopher J. Waller, a member of the Federal Reserve Board of Governors addressed three main findings of the above paper during the 2024 U.S. Monetary Policy Forum which took place on March 1, 2024.

• Asymmetry Between QE and QT: “The punchline here is that QE is conducted under different market conditions than those that occur when QT is done, so it is not surprising that the effects will be different. The authors’ findings that QE has asymmetric effects compared to QT is not a puzzle but an indication that central banks timed QE and QT in the right manner such that society was better off.”
• Impact on Government Bond Yields: “[E]ven if QE is an open-ended program, QT is more likely to resemble a closed-ended program. Central banks usually have an idea of how large they want their balance sheet to be when QT ends; therefore, once the pace of QT is announced, markets should be able to effectively price in the entire program at the announcement of the plan. After that, the actual execution of QT is simply validating the beliefs that market participants had at the announcement. This is why many refer to QT as merely draining unneeded reserves, which should be as interesting as watching paint dry.”
• Investor Behavior and Demand for Government Debt: Waller finds that for U.S. Treasury securities, since the 2022 start of QT, nonprofit organizations and actual households, not hedge funds are argued in the above paper, have boosted their market share the most, and broker-dealers have also increased their share. For agency MBS, not only has the market shares of those two investor types increased, but so has the market shares of money market funds. As a result, the pace of runoff is not a problem because the buyers are not a narrow set of deep-pocketed, sophisticated investors but rather the American public.

Thinking about longer-term issues related to the Fed’s portfolio, I want to mention two things. First, I would like to see the Fed’s agency MBS holdings go to zero. Agency MBS holdings have been slow to run off the portfolio, at a recent monthly average of about $15 billion, because the underlying mortgages have very low interest rates and prepayments are quite small. I believe it is important to see a continued reduction in these holdings.
Second, I would like to see a shift in Treasury holdings toward a larger share of shorter-dated Treasury securities. Prior to the Global Financial Crisis, we held approximately one-third of our portfolio in Treasury bills.

Thoughts on Quantitative Tightening, Including Remarks on the Paper “Quantitative Tightening around the Globe: What Have We Learned?”
By: Christopher J. Waller, Member of the Federal Reserve Board of Governors