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The Federal Reserve is carrying out a significant restructuring of the financial system, largely unnoticed by most people. This is often compared to the undertaking of moving a herd of elephants through a crowded city without drawing attention.
However, this isn’t about the Fed’s decisions on short-term interest rates, which remain fairly high at around 5.33% as part of their ongoing efforts to control inflation. Rather, this restructuring refers to the lesser-known strategy of the Fed known as quantitative tightening (Q.T.), which involves the reduction of the Treasury bonds and mortgage-backed securities on its extensive balance sheet.
Recently, the central bank announced its decision to reduce the pace of this asset reduction process from its high of $95 billion a month to $60 billion starting June. What they’re doing isn’t selling these securities, but simply allowing some to mature without reinvesting the proceeds.
Though these figures seem sizable, they’re only a fraction when compared to the actual size of the central bank’s assets, peaking at nearly $9 trillion two years back, approximately one-third of the US’s annual gross domestic product. Presently, after implementing measures, the Fed has been able to reduce the total to about $7.4 trillion. Despite removing roughly $1.6 trillion, there’s still an enormous amount of bonds and securities in the Fed’s possession following two years of quantitative tightening.
Comprehending the concept of quantitative tightening is crucial for various reasons:
– It has a direct impact on financial markets, making living conditions more difficult for millions by exerting upward pressure on the Treasury and mortgage markets.
– It’s a risky process. Earlier attempts at the process, such as in 2019, caused disruptions in financial markets. If hastily executed, this could happen again.
– If carried out slowly as per the current plans, the Fed will still retain trillions in securities for the foreseeable future. An experiment that was started during the 2008 financial crisis is now becoming a permanent fixture; giving the Fed, or the institution in control, significantly expanded powers.
– The slow pace of quantitive tightening is one of the contributing factors for the Fed’s inability to fund the national budget.
Contrastingly, the Fed has also increased interest rates, which inversely affect bond prices. Consequently, the value of the Fed’s asset holdings has decreased, incurring a loss of over $133.3 billion.
Quantitive tightening is the opposite of an unconventional monetary policy called quantitative easing. Under Ben S. Bernanke’s leadership, the Fed adopted this approach after Lehman Brothers collapsed in 2008, which resulted in a crash of the economy and the markets. The aim was to decrease yields in the Treasury market resulting in lower yields elsewhere and stimulate spending and investment by businesses and consumers.
Though the plan evolved into a regular part of the Fed’s toolbox that is used frequently by some economists, it has been compared to feeding an addiction according to Raghuram Rajan, a finance professor. He elaborated that US banks have become accustomed to easy liquidity coming from Fed’s expansionary policies and that extracting it has proven very challenging.
Although the Fed hasn’t exited its quantitative easing strategy to date, the total assets held now is more than triple the amount held when Bernanke testified in 2010 about the eventual end of quantitative easing. This is even after the most aggressive circular of “tightening”.
Reducing quantitative tightening is difficult as it implies ending the Fed’s active participation in bond and mortgage markets, a drastic reduction in holdings, and a return to operations before the crisis. Over the years, instead of selling purchased assets, the Fed has been taking a slower approach by allowing maturing bonds and other securities to “run off” or “roll off”. The pace at which it’s done has been slow, causing a projected decline of no lower than $6 trillion in total assets in the next few years, and then a subsequent rise.
When the total assets on the Fed’s balance sheet shrinks, it has sometimes caused significant disruptions. Regardless, the Fed has skillfully managed the draining of over a trillion dollars from the financial system, without raising many eyebrows. But by keeping high financial firepower, the potential for more serious problems always remains.
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