(Bloomberg Opinion) -- With the U.S. Federal Reserve on track to complete its asset purchase program in March and start raising interest rates soon thereafter, attention has turned to the next step in the monetary tightening process: reducing the central bank’s holdings of more than $8 trillion in Treasury and mortgage-backed securities.
For those who worry that this “quantitative tightening” could bring unpleasant surprises along the lines of the money-market convulsions that occurred in 2019, I have comforting news: The Fed will be seeking to ensure that it’s about as exciting as watching paint dry.
Judging from the minutes of their December policy-making meeting, Fed officials are already working on a plan. It will bear similarities to the last quantitative tightening that began in October 2017, in that it will entail allowing the holdings to mature with caps limiting the monthly amounts, will be communicated well in advance and will be secondary to the Fed’s main policy tool, the federal funds rate. But officials also noted two key differences that suggest quantitative tightening will start sooner after interest-rate liftoff and will go faster. First, the economic outlook is stronger, with higher inflation and a tighter labor market. Second, the Fed’s holdings are much larger and of shorter average maturity.
During the last economic expansion, the transition through the stages of monetary policy normalization was very slow. The balance sheet runoff didn’t begin until three years after the Fed completed its asset-purchase program. This time around, the interval might be less than a year. The faster transition, however, does not necessarily imply that the runoff will start at a lower level of short-term interest rates. During the previous cycle, it began only after the federal funds rate target was above 1%; with the central bank poised to raise rates multiple times in 2022, that level could be reached by the end of the year.
Some Fed officials have argued that quantitative tightening should begin even sooner, at a lower federal funds rate, with the aim of pushing up longer-term interest rates and supporting financial institutions (which tend to lend at long-term rates and borrow at short-term rates). While I can’t rule this out, I’d note that starting at a lower rate level would conflict with the Fed’s commitment to the federal funds rate as the primary tool of monetary policy. If you emphasize getting the federal funds rate up above 1% first, then you’ll have more ability to reverse course and use it as a stimulative tool if the economy gets hit with an adverse shock. Officials understand the effect of interest-rate changes much better than that of balance-sheet changes. This is why they employ the latter only in extreme cases, when interest rates have hit the zero lower bound.
Fed officials also discussed the turmoil in money markets that the last episode of quantitative tightening helped trigger. As the central bank shrank its balance sheet, it also reduced the aggregate amount of reserves in the banking system. In September 2019, reserves fell below the level that banks desired, making them reluctant to lend short-term and causing rates to spike in the “repo” market, where various financial institutions borrow money to fund investments in Treasuries and other securities. There’s much less risk of this happening again because the Fed has since established a broad-based standing repo facility that financial institutions can access quickly if they need funds.
Another issue is whether the Fed should adjust the composition of its holdings. Since March 2020, the Fed has been purchasing both Treasuries and agency mortgage-backed securities, but its longer-term goal is to hold only Treasuries. Some Fed officials have suggested allowing the mortgage-backed holdings to run off more quickly, or even reinvesting the proceeds into Treasuries. Although this debate might attract a lot of attention in coming months, the Fed will probably stick with the strategy of reducing holdings at rates comparable to those of prior purchases.
All told, I expect quantitative tightening to proceed smoothly. First the announcement will come explaining how it will all work, then the runoff will start when interest rates have been raised sufficiently from the zero lower bound, then (economic circumstances allowing) it will continue on autopilot until the balance sheet reaches the point where the supply of bank reserves is still modestly above the underlying demand. The shift in holdings from the Fed to private investors, along with the decline in reserves, will probably cause the risk premium on longer-term Treasuries to increase, pushing up longer-dated yields. But long-term rates will not rise as much as short-term interest rates, so the yield curve will flatten.
This will all be a lot less exciting than some ardent Fed-watchers anticipate, which is exactly what Fed officials will be aiming for.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Bill Dudley, a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics, is senior adviser to the Griswold Center for Economic Policy Studies at Princeton University. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.
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