The Fed Is About to Go Full Throttle on QT. Fear Not.

(Bloomberg Opinion) -- The Federal Reserve’s quantitative tightening program will ramp up to its full potential in September, increasing from $47.5 billion to $95 billion per month. Some market participants are concerned this additional monetary tightening will have negative consequences on risk assets and the economy. Given that quantitative easing — buying US Treasuries and mortgage-related securities —  helped firm the economic recovery and provided a lift for the stock market and other so-called risk assets, it seems quantitative tightening could have the opposite effect. But these are unusual times, and such an assumption could prove costly.

Critics of QE may downplay its effect on the economy, but it is generally accepted that the policy provided a boost to financial asset prices, especially during times of market stress. Unfortunately, forecasting stock prices is not as simple as overlaying a graph of the size of the Fed’s balance sheet assets over the S&P 500 Index.

Other factors apart from QE and QT directly affect economic liquidity. Incorporating inputs such as the Fed’s reverse repurchase agreement facility, which allows financial institutions to park excess cash with the central bank, and the Treasury General Account, which operates like the government’s checking account at the central bank. These items create a more robust liquidity gauge that better explains recent stock market movements, while also providing an improved framework to forecast the effects of QT.

When the Covid-19 pandemic hit, the Fed engaged in an unprecedented QE program, buying about $120 billion of bonds every month. At the same time, the government enacted the largest fiscal stimulus in decades, which pushed trillions of dollars into the economy. The liquidity created from QE and fiscal stimulus was so great that commercial banks no longer wanted deposits from large institutional clients because there were not enough safe assets available to purchase.

To amend the situation, the Fed expanded its reverse repo program, which consisted of the Fed delivering high-quality collateral with the promise to buy it back in a certain number of days at a higher price. Reverse repos are a liquidity draining operation, much like QT. They both involve the Fed decreasing the amount of cash in the system by increasing the amount of bonds. Usually, the Fed would only engage in repo operations with primary dealers, but the need to soak up extra liquidity was so great that it widened the list of eligible counter parties to include mutual funds and other non-traditional accounts.

The overabundance of liquidity is evident from the reverse repo operation’s growth to its present $2.18 trillion size from virtually nothing before the pandemic.

Reverse repos are only one example of a Fed operation that affects liquidity, but there are others, including those from other branches of government. One that has gained considerable importance over the past decade is the Treasury General Account. In the past, when the government issued fixed-income securities and took in taxes, they almost immediately distributed the funds from those endeavors. As a result, the TGA rarely had a balance.

In the Covid era, however, there have been times when the TGA has increased to previously unimagined levels, reaching almost $1.8 trillion in mid-2020. Increases in the TGA have the same effect as QT. Bonds are issued and cash withdrawn from the financial system, but the money is not distributed into the economy. It is a liquidity draining operation.

By combining the size of the Fed’s balance sheet with the amount of reverse repos outstanding and the TGA balance, we can create a liquidity indicator that better explains movements in stock prices than just the Fed’s balance sheet alone.

There is worry about the scheduled increase in QT could have on stock prices, but the unique situation with the large reverse repo balance could mute any potential affect. If the Fed had securities on its balance sheet that matched the maturity profile demanded by the institutions engaging in reverse repos, it could sell an amount equal to the total reverse repo balance to these institutions, reducing the need for reverse repos and elicit no change in the financial or real economy. Though there might be a duration mismatch in the type of assets demanded, an actual withdrawal of liquidity is not the problem.

On top of that, the actual amount of monthly QT is not that large. Given that the reverse repo balance is $2.18 trillion, and the Fed is scheduled to reduce its balance sheet by $95 billion per month, it would take almost two years to work off reverse repos solely though QT. Plus, the variability of the TGA balance shows that the economy can handle the scheduled liquidity withdrawal. From the end of November 2021 to April 2022, the TGA increased by $816 billion. That was equivalent to a QT of $163 billion per month, far below the scheduled and well-telegraphed increase next month.

Although throughout history there have been a few times when central banks had successfully reduced their balance sheets assets, this is an unusual time. The extraordinarily large reverse repo balance shows the true extent of the extra liquidity in the financial system. So as QT unfolds, it will be important to watch whether the reverse repo balance declines and how fast. The QT numbers appear large, but when compared to the fluctuations from the TGA account and the reverse repos, the scheduled increase is rather tame.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Kevin Muir is a former institutional equity derivative trader who now writes the MacroTourist newsletter.

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