Fed Balance Sheet Shrinkage May Be Smaller Than It Seems

After accounting for changes in duration and reverse repos, headline estimates of quantity-based policy tightening may be overstated.

The Federal Reserve’s holdings of Treasury debt and government-guaranteed mortgage bonds (agency MBS) have shrunk by more than $1.6 trillion (nearly 20%) since the peak almost two years ago. Yet this does not seem to have done much to tighten financial conditions—even though that is supposed to be the entire point of shrinking the balance sheet.

Intriguingly, Fed officials seem mostly unbothered by this.¹ In fact, they recently committed to slow the pace of balance sheet shrinkage, as I had warned readers back in January, because they want to avoid creating any unnecessary disruptions in the banking system. Whether or not that is the right choice, it may limit officials’ willingness to lower short-term interest rates.

QT1 vs. QT2

At first glance, the drop in the Fed’s holdings has been larger and faster than the last time the Fed began to unwind its portfolio almost 10 years ago. In the beginning of 2014, the Fed started buying additional bonds for its portfolio at a slightly slower pace than before. This “tapering” of purchases dragged on until almost the end of 2014. Officials only started to let the balance sheet shrink in October 2017. From then until they felt compelled to reverse course in September 2019, the Fed’s securities portfolio shrank about 16% peak-to-trough.

This time around, Fed officials decided to start slowing asset purchases in November 2021, stop entirely at the beginning of March 2022, and then pivot to shrinkage starting in June. A few months later, the Fed had decided to accelerate the pace of shrinkage. This was a conscious decision to be much more aggressive than what had happened earlier. Lael Brainard, then the Fed’s number two, explained the rationale in a speech on April 5, 2022:

It is of paramount importance to get inflation down…Given that the recovery has been considerably stronger and faster than in the previous cycle, I expect the balance sheet to shrink considerably more rapidly than in the previous recovery…The reduction in the balance sheet will contribute to monetary policy tightening over and above the expected increases in the policy rate reflected in market pricing and the Committee's Summary of Economic Projections.

The last time the Fed cut back on its bond-buying (in mid-2014), stock prices flat-lined, credit spreads blew out, the dollar soared, commodity prices plunged, and core capital goods orders tanked. By the time the balance sheet finally started shrinking, however, the economic and financial environment stayed relatively benign.

This time was different. While there were some symptoms of monetary tightening between the end of 2021 and mid-2022, they were much more mild than in 2014-2016. Moreover, conditions have been anything but “restrictive” since mid-2022. The environment now is still far more favorable to risk-taking than before the pandemic. GameStop and other meme stocks are even rallying again, while many cryptos are once again at the highs.

Why?

One possibility is that changes in the Fed’s balance sheet have little effect except when they are stepping in to stop market panics, as in the first months of the pandemic. If so, “quantitative tightening” that occurs on a telegraphed schedule should never have any meaningful impact on financial conditions. A recent paper by Wenxin Du, Kristin Forbes, and Matthew Luzzetti found that “the effects of QT have been very small (or nonexistent) on average, statistically insignificant to date, and much less than the impact of QE (in reverse).” From this perspective, whatever happened in 2014-2016 should therefore be attributed to factors other than prospective changes to the Fed’s securities portfolio.²

While I find this argument compelling, there are at least two other plausible reasons why the more recent balance sheet “tightening” has been so much milder than the one ten years ago.

The Asset Side: Duration Games

The Fed bought bonds because officials wanted to change the mix of assets available for everyone else to buy. The hope was that investors would be willing to take more credit risk and liquidity risk if they were getting paid less to take other kinds of risk. In particular, the Fed would buy exposure to interest rate volatility by hoovering up longer-dated U.S. Treasury bonds and agency MBS. (American mortgages are particularly sensitive to changes in interest rates because borrowers can refinance when rates fall with no prepayment penalty.)

This means that changes in the size of the balance sheet alone do not tell you much about the expected impact on financial conditions. The composition of the balance sheet matters at least as much.

The Federal Reserve Bank of New York, which manages the Fed’s bond portfolio, publishes duration-adjusted estimates of its holdings as part of its annual report on open market operations.³ This explains at least some of the differences noted above.