How does the FED run its quantitative tightening?

FED released a paper last year that argued quantitative tightening by the Fed over a two-year period at a monthly pace of USD95bn per month is equivalent to 50-bps in fed rate hikes.

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Central banks have bolstered their rate hikes with quantitative tightening (QT). It leads them to argue that the degree of monetary tightening being undertaken is more than that suggested by rate hikes alone. This is not incorrect but the robustness of economies, despite the fastest rate hikes in many decades, might suggest that it is still not enough.

For a long time now economists in both the public and private sector have tied to estimate an equivalence between quantitative easing (or tightening) and rate changes. Most often, the equivalence has been couched in terms of bond yields, but policy rate equivalence has also been guesstimated.

The Federal Reserve, for instance, released a paper last year that argued quantitative tightening by the Fed over a two-year period at a monthly pace of USD95bn per month is equivalent to 50-bps in fed rate hikes. Hence, if the Fed takes the fed funds rate up to 5.25%, as its members suggested at the last forecasting round in December, the ‘real’ fed funds target peak will be 5.75% if we add in the quantitative tightening effect.

In fact, as far as we can tell, this is quite a conservative estimate relative to some of those we’ve seen within the private sector but, for the purposes of this discussion let’s use the Fed’s estimate. On the surface at least the calculation still suggests a decent effect and if we think that the Fed might undertake more QT than USD2.5tr, either by upping the pace from USD95bn per month or extending QE for a number of years, then even as policy rates come down the ‘real’ fed funds target will not come down as much due to this QT effect. But if all this seems to suggest that the Fed is being very aggressive, why is it the case that the economy still seems to be quite robust?

What’s more, we can go further and say that we are seeing similar quantitative tightening (and rate hikes, of course) from other central banks and yet, here too economies appear a bit more robust than feared, but perhaps at a cost of more persistent inflation. We also have to bear in mind, of course, that countries are vulnerable to spillover effects.

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For instance, tighter US policy via either rate hikes or QT can tighten monetary conditions elsewhere. So, all round it looks as if monetary conditions have tightened a lot. However, Mr. Steve Barrow, Head of Standard Bank G10 Strategy thinks it is important to consider the starting point. In other words, to accept that prior quantitative easing, which was far in excess of any quantitative tightening to date, pushed “real” policy rates, such as the fed funds target, far below the rates that we saw on our screens.

To use a very simplistic, and admittedly unrealistic, example; if we reversed the Fed’s QT equivalence calculation to estimate just how much the Fed’s QE has lowered the “real” fed funds rate we’d find that, rather than dropping to a low of 0.25%, the “real” rate fell to more like -1.5%. Now, we can’t just assume the calculation for QT works for QE as well; the impact could be greater or smaller.

“We’d actually argue that QE is worth more, meaning that the low for the “real” fed funds rate was probably below -1.5%. But whatever the proper level, the key issue is whether this “starting point” for rates is of importance when it comes to the ongoing stance of policy. We think so and it is similar to an argument that we have made in the past that quantitative easing should be seen as a “stock” concept, not a “flow” concept. In other words, if the Fed has an inflated balance sheet because of QE, we should still see this as imparting stimulus to the economy even if this stock of assets is being reduced by (the flow of) asset sales. This being said, we would not, for one moment argue that this is the only factor holding up economies. But we do think it is a factor that’s likely to mean that central banks will have to lift policy rates to levels above those priced in by the market”, said Mr. Steve Barrow.