What Will Quantitative Tightening Look Like in 2022?
(5 min read)
(5 min read)
• QT2 could start around mid-year with initial reinvestment caps at $20bn and raised faster and higher than during QT1.
• The Fed decision to not extend the exclusion of reserves from the SLR computation has created an excess reserves supply, driven money market rates through the Fed RRP rate and led to the Fed funding its securities portfolio through the RRP rather than through reserve issuance.
• As the Fed balance sheet shrinks, market rates are likely to rise over the Fed RRP rate, which would see the RRP fall ahead of reserves.
• Negative risk assets, as QT2 signals weaker Fed support to markets.
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As explained in our primer Quantitative Tightening and the Fed balance sheet, recent Fed communications imply QT2 in 2022 is likely. The Fed has already gone through a balance sheet shrinking episode in 2017-19 (hereafter QT1, with the forthcoming QT referred to as QT2). In the minutes of the December 2021 FOMC meeting, the Fed indicated that it would follow the same shrinking technique it used for QT1 but implement it sooner and faster to reflect that this time, inflation is higher, unemployment is lower and the balance sheet much larger.
The Fed will rely on reinvestment caps to let securities roll off its balance sheet. That is, it will reinvest principal repayments on its securities holdings only to the extent that they exceed a pre-announced cap. The runoff rate will therefore be driven either by principal repayments when those are below the cap, or by the cap when it is exceeded by principal repayments.
In his 11 January confirmation hearings, Fed Chair Jerome Powell stressed that the Fed would need 2-4 meetings to finalize the details, which suggests a mid-2022 start. The Fed further indicated that the pace of QT2 would be adjusted ‘in response to economic and financial developments’. This is unlike QT1, when the increase in the caps was on a pre-set course (growing by $10bn every three months).
The Fed is likely to start with small reinvestment caps, to test the market reaction. Since the securities portfolio is about twice as large as October 2017, when QT1 started, the initial monthly reinvestment caps could be about double those in 2017 – about $20bn.
Based on no adverse market reaction, the caps then would be raised faster and more frequently than during QT1. In this context, Atlanta Fed President Raphael Bostic’s suggested $100bn monthly runoff appears more likely in 2023 than 2022.
For investors, it is important to figure out whether QT2 will shrink the reserves or the RRP. This is because reserves are a more powerful form of liquidity than the RRP. When banks have too many reserves, they tend to lower the interest rates they pay on deposits to 0 (or even to negative numbers if you account for deposit fees). That spurs depositors to seek yield elsewhere.
By contrast, the Fed RRP involves a smaller and more specialized set of financial intermediaries for whom the Fed is a default option. Also, the Fed RRP represents about $1.8tn against about $5.5tn for all outstanding RPs in the US economy (including the Fed).
How will the shrinking of the Fed balance sheet impact RRP and reserves? As Chart 2 shows, the expansion of the RRP to about $2tn started in April 2021. Previously, the RRP had been stable at around $0.3tn. As the RRP surged, bank reserves flattened out: in effect, the Fed switched the funding of the increase of its securities portfolio to MMF and GSE, from banks (the Bank Policy Institute Bill Nelson has a great write up on this topic).
What triggered the increase in the RRP facility? Responding to the crisis, the Fed increased reserves by $2.5tn – a very large amount for banks. Their reserves are now back to the 2014 highs, when their loan book was at its lowest. To allow banks to absorb the massive increase in reserves, the Fed in March 2020 decided that reserves holdings would be excluded from the calculation of banks’ capital requirements (specifically, the supplementary leverage ratio (SLR), a ratio used to compute banks’ capital needs).
In March 2021, the Fed let the exclusion lapse, and the holding of large reserves by banks became much more expensive. Consequently, their demand for reserves fell, and they lent their excess liquidity in the money market. As a result, the market RRP rate fell below the Fed RRP rate, and MMF and GSE started lending to the Fed.
This analysis suggests to me that the early stages of QT2 are more likely to see a decline in RRP than reserves. As the Fed balance sheet shrinks, the above process will reverse, markets RRP rates will rise back above the Fed RRP, and RRP lending to the Fed will fall, with only limited changes in banks’ reserves.
As always, the market consequences depend on how much is already priced in by the markets. Gauging how much QT is priced in at this stage is difficult. The Fed surveys of primary dealers and market participants, which includes questions on expectations of future Fed balance sheet size, will not be released until three weeks after the 26 January FOMC meeting.
Still, the Fed has just kicked off the QT discussion. And a QT2 start in mid-year does not seem to be market consensus yet. Overall, even though it is likely to impact RRP before reserves, QT2 seems to me negative for risk assets as it further signals weaker Fed support to markets.
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