By John Plassard, senior investment specialist at Mirabaud Group
Whether in the United States, Europe or Switzerland, there is a lot of talk around interest rates at the moment. However, very little is said about changes in central bank balance sheets. And yet, these trends are extremely important. It’s vital that we take a closer look and consider the consequences.
The facts
Faced with inflation well above its long-term objective, the Fed began to end its accommodative monetary policy in March 2022. It ended quantitative easing (QE) and then began to implement quantitative tightening (QT) in June.
Then, the banking crisis (and it was a crisis) at the start of the year upended the Fed’s plans, so the balance sheet was increased in order to avoid a systemic crisis. The downward trend resumed in May this year, and we are now back at the May 2021 level.
Changes in the Fed’s balance sheet
Total assets on the Fed’s balance sheet fell by $89 billion in October to $7.87 trillion, the lowest level since May 2021, the Fed revealed earlier this week. Since the peak of quantitative easing in April 2022, total assets have fallen by $1.1 trillion.
In parallel, inflation has fallen back from its peak in 2022, but it is still almost twice as high as the Fed’s target. By contrast, during the first QT between November 2017 and August 2019, when the Fed’s total assets dropped by $688 billion, inflation was below or at the Fed’s target (1.8% core PCE in August 2019), and the Fed was just trying to “normalise” its balance sheet.
But during the COVID-19 crisis the stock of QE assets swelled much more, so there is now much more to take off the pile.
Treasury bills:
Since peaking in early June, Treasury holdings have fallen by $899 billion to $4.87 trillion, the lowest level since March 2021. The Fed has shed of 27.5% of the $3.27 trillion in Treasury securities it accumulated during the pandemic QE.
Treasury notes (2- to 10-year securities) and bonds (20- and 30-year securities) “roll off” the balance sheet mid-month or at the end of the month when they mature and the Fed gets paid face value for them.
The roll-off is capped at $60 billion per month, and about that much has been rolling off, minus the inflation protection the Fed earns on Treasury Inflation Protected Securities (TIPS) which is added to the principal of the TIPS.
Mortgage-backed securities:
Since the peak, the MBS balance has fallen by $277 billion to $2.46 trillion, the lowest level since September 2021.
The Fed only holds government-backed mortgage securities, and taxpayers bear the credit risk. Mortgage-backed securities roll off the balance sheet primarily through the principal payments that holders receive when mortgages are repaid (mortgaged homes are sold, mortgages are refinanced) and when mortgage payments are made.
Soaring mortgage rates led to a collapse in refinancing and a fall in house sales, slowing mortgage repayments and, consequently, capital payments, with the liquidation of mortgage-backed securities running at between $15 billion and $21 billion a month, well below the $35 billion ceiling.
Discount window:
The discount window remained roughly unchanged in October, at the near-nothing level of $2.9 billion, compared with $153 billion during the banking panic in March.
Discount window lending to banks is as old as the Fed. The Fed currently charges banks 5.5% to borrow at the discount window, and banks must provide collateral under strict conditions and at “fair market value”. The banks repay these expensive discount window loans as soon as they can.
Bank term finance programme (BTFP):
The BTFP increased by $1.4 billion in October to reach $109 billion. The BTFP, created during the bank panic, is less punitive and more flexible than the Discount Window. Banks can borrow for up to one year, at a fixed rate, pegged to the one-year overnight index swap rate plus 10 basis points. The collateral is valued at purchase price rather than at the lower market price.
This facility is small compared to the $22.8 trillion in commercial banking assets held by the 4,100 US commercial banks.
FDIC loans:
FDIC loans fell by $16 billion in October, to $47 billion. The FDIC sold the assets it had assumed with the takeovers of Silicon Valley Bank, Signature Bank and First Republic. Once asset sales are completed, the FDIC sends the proceeds to the Fed to repay the outstanding loans. The FDIC also made a $50 billion loan to JPMorgan to finance part of the First Republic liabilities that JPMorgan had assumed.
What is quantitative tightening?
The Atlanta Fed has attempted to answer the question of how to quantify the equivalence between interest rate hikes and quantitative tightening. Using a simple “preferred habit” model, the institution estimates that a passive withdrawal of $2.2 trillion of nominal Treasury securities from the Federal Reserve’s balance sheet over three years is equivalent to an increase of 29 basis points in the current federal funds rate in normal times, but 74 basis points in times of turbulence.
According to another Fed document published in June, $2.5 trillion of QT over the next few years would be roughly equivalent to raising the policy rate by just over 50 basis points.
Solomon Tadesse, head of quantitative strategies for North America at Société Générale, is much less optimistic. He estimates that every $100 billion of QT is equivalent to a 12bp increase in the key rate.
He believes that to keep inflation in check, the Fed may need to tighten policy by a further 9 percentage points, split evenly between rate hikes and QT.
Why tighten the Fed’s balance sheet?
There are several reasons for a QT. The first is to reach the Fed’s target of 2%. The second is to pay less interest on the Fed’s balance sheet holdings (even if we agree that the US Federal Reserve cannot go bankrupt).
A final reason to engage in QT is to free up capacity for future QE.
Indeed, if the Fed’s balance sheet were to continue to grow, it could, in theory, run out of Treasuries or other acceptable assets to buy in order to conduct QE in the future.
Former Richmond Fed President J. Alfred Broaddus Jr. and policy advisor Marvin Goodfriend addressed this issue in very different circumstances in a 2001 article in the Richmond Fed Economic Quarterly.
At the time, the federal government was enjoying a budget surplus, and Broaddus and Goodfriend feared that the Treasury bill market would dry up if the United States had to repay its debt.
Although this has not happened (and indeed seems difficult to imagine today), the Fed could still face the same problem if its asset purchases were to exceed the supply of Treasury bonds.
Moreover, a constantly growing balance sheet would expose the Fed to even greater losses in a tightening cycle.
“The Fed would rather not have this ratchet effect where the balance sheet just keeps getting bigger, because at some point, you have a problem”, said Yale finance professor William English. “I think they want to be clear that this is a counter-cyclical policy that they’ll engage in to provide support when it’s necessary, and they’ll unwind when it’s appropriate to do so”.
In short, a QT for a … (future) QE!
Investors are definitely focused on the ECB and Fed rate decisions over the next few weeks. Changes in the balance sheets of central banks are essential, indeed crucial, for the future of financial markets and inflation. Watch them very (very) closely.
