Jerome Powell, chairman of the Federal Reserve, has said the central bank has "a long way to go" in curbing inflation, suggesting that its balance sheet reductions — known as quantitative tightening — may continue for some time.
Bloomberg News
The noted physicist and former warden of the Royal Mint Sir Isaac Newton is often credited with coining the expression "What goes up must come down." Unfortunately he coined the considerably clunkier expression: "To any action there is always an opposite and equal reaction; in other words, the actions of two bodies upon each other are always equal and always opposite in direction." We can all use a good editor from time to time.
The Federal Reserve's balance sheet doesn't adhere to the laws of gravity, however. That explains how it has been able to balloon in size by many orders of magnitude since the financial crisis of 2008 and remain that big — or even expand — without any discernible outer limit, save for the Fed's own prudence in pursuing its stable-pricing objective.
When rampant inflation stirred from its long dormancy in 2021, that prudence kicked into high gear. In addition to hiking interest rates at a speed that we haven't seen in years, the Fed also embarked on a project of reducing its liabilities by letting assets on its balance sheet roll off at a predictable rate. The idea there is that reducing the Fed's liabilities — that is, less money out there for the Fed to be liable to honor — furthers the goal of making money more expensive to borrow, thus muting inflationary pressures.
Those effects are starting to be felt, at least in one of the first places you would expect to find them: the Fed's overnight reverse repurchase facility, or ON RRP. The volume of transactions in the facility has been steadily going down in the last several months from about $2.3 trillion this spring to about $1.7 trillion today — and falling still further.
But this reminds me of a nerds-only parlor game that Fed watchers used to play in the mid-2010s when the Fed decided to very incrementally raise interest rates and reduce its balance sheet: The balance sheet clearly is too high and needs to come down, but equally clearly will not go all the way back to its historical norm of under $1 trillion. So what's the secular neutral balance sheet level?
Turns out the answer back then was something like $3.5 trillion, though it started rising again in 2019 and then took its great leap forward in 2020. But now that the Fed is in a shrinking phase again, that game is again back in fashion. So how low will the Fed go this time?
This is an important question because the balance sheet serves not only as a liability for the Fed but as a liquidity reserve for banks — a source of funds that they can use to keep themselves stable, and that the Fed indeed requires them to hold. There is also some scholarship suggesting that quantitative tightening — reducing the Fed's balance sheet — has a greater impact on the economy than its opposite, quantitative easing. Quantitative tightening not only reduces the Fed's liabilities but also prevents it from acquiring new ones, meaning the Treasury and mortgage-backed security assets that the Fed would be buying in a neutral or quantitative easing phase must be bought by market actors instead.
Fed Gov. Chris Waller said earlier this year that the Fed could reduce its balance sheet by about $2 trillion without anyone missing it, and that very well may be true. Again, there is little doubt that QT serves the Fed's core mission of price stability under these circumstances, and does so in a way that doesn't require it to raise headline interest rates quite as high as they otherwise would have to.
But smart observers predicted that the Fed would be largely done with its balance-sheet reduction by now, and that doesn't seem to be the case. Indeed, Fed Chair Jerome Powell said in his Jackson Hole speech last month that the central bank still has "a long way to go" in winning its fight against inflation. That doesn't sound like the Fed is letting up on the gas any time soon — as of this writing, the Fed is not quite halfway toward that unmissable $2 trillion reduction mark.
If I could hazard a guess as to where the Fed will ultimately land, it would be that the Fed will leave the balance sheet alone not when it arrives at a predetermined number, but rather when it arrives at an economic moment when either the economy requires quantitative easing again or inflation has been sufficiently tamed as to give the Fed sufficient cover to stop. If there is one universal law of monetary policy, it's that there is no universal law of monetary policy.
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