Quantitative Tightening 101

Teaching note on Quantitative Tightening

Jun 09, 2024

One interesting observation by looking at the balance sheet reduction in the United Kingdom and the U.S. is that, while the balance sheet shrinks in both cases, the amount of reserves does not vary much in the U.S. while it declines in the United Kingdom.1

In this note, I revisit the way Quantitative Tightening (QT) operates and why, in the specific case of the U.S., its effects have been muted. In this context, we observe that:

Central Banks have started the normalization of their balance sheet through Active (the Bank of England for example) or Passive Quantitative Tightening (the Federal Reserve for instance).
In principle, Active Quantitative tightening has direct implications for the adjustment in terms of reserves and could be associated with a steeper yield curve relative to Passive Quantitative Tightening.
From a policy standpoint, active quantitative tightening (QT) is a more direct approach to tightening financial conditions because it increases term premia and enhances the transmission mechanism of monetary policy. This approach is particularly relevant when long-term yields are more directly related to consumer and firm choices.

What is Quantitative Tightening?

QT is essentially the reverse of Quantitative Easing (QE), i.e. it is when the Central Bank aims to return its balance sheet to normal level by reducing the reserves in the system through a decrease in its bond holdings.

There are two strategies for achieving the desired balance sheet size: passive and active, each influencing the speed of normalization. With passive management, the Central Bank ceases to reinvest in maturing bonds. In contrast, active management involves the Central Bank proactively selling its bond holdings.

Whether through the natural expiration of bonds or deliberate sales, both methods should, theoretically, influence the market upon announcement (or as expectations are adjusted) and subsequently lead to a gradual adjustment in interest rates. The core principles of balance sheet normalization include predictability and gradualism, aimed at ensuring that financial markets respond smoothly and avoid any sudden disturbances, such as the "Taper Tantrum" in 2013,– when the Federal Reserve announcement of tapering QE led investors to sell bonds out of fear of a potential market crash.

Passive Quantitative Tightening

Under passive quantitative tightening, the Federal Reserve collects principal payments from its holdings of Treasury securities but does not reinvest them in new Treasury issues. In this case, the Treasury pays the Fed with cash from the TGA as the securities mature. The Fed holds fewer assets (its holdings of Treasury securities decrease) and has fewer liabilities (cash held by the Treasury at the Fed decreases), so the size of its balance sheet decreases.

In what is next I will assume that, when the securities held by the Federal Reserve mature, the Treasury issues a corresponding amount worth of new securities at the same time, so the size of the Treasury General Account remains unchanged.

The effects of these operations can be demonstrated through the balance sheets of the entities involved in this process, including the Federal Reserve, the Treasury, the commercial banks, and the private sector (non-banks).

The above-mentioned operation unfolds as follows. The Treasury issues debt (bonds and coupons, +B) to repay its debt. Then, Treasuries are sold to the private sector. For this operation, the Federal Reserve credits the Treasury General Account (TGA) by the value of the Treasuries sold to the private sector (+ ). The private sector swaps assets: from deposits to Treasuries (-D). This implies a corresponding adjustment in the commercial bank deposit and reserves at the Central Bank (red font operation).

The second leg is when the Treasuries uses its proceeds from selling bonds to the private sector to repay the debt at maturity at the Central Bank (the Federal Reserve). In this case, the Federal Reserve withdraws the corresponding amount from the TGA to repay the Treasuries held at the Federal Reserve. (green font operation)

The operation results in a shrinking balance sheet from the Central Bank's point of view corresponding to the amount repaid by the Treasury.

Eventually, the balance sheet of commercial banks and the Fed shrinks. If the commercial bank sector buys the newly issued Treasuries, then the commercial bank sector swaps assets between reserves and Treasuries.

Active Quantitative Tightening

Under active quantitative tightening, the Fed proactively sells a predefined quantity of Treasuries or other securities to the private sector. The impact of these actions can be illustrated through the balance sheets of the actors involved in this transaction (i.e. the Fed, Treasury, Commercial Banks, and Non-Banks).

The Federal Reserve sells its holdings of Treasury to the private sector. Nothing happens at the level of the Treasury. In this operation, the Federal Reserve debits the reserve account of the commercial bank where the buyer of the Treasuries has an account. This implies a corresponding adjustment in the commercial bank deposits and reserves at the Central Bank (red font operation).

Once again, the operation results in a shrinking balance sheet from the Central Bank's point of view corresponding to the amount repaid by the Treasury.

Eventually, the balance sheet of commercial banks and the Federal Reserve shrinks. As before, if the commercial bank sector buys the newly issued Treasuries, then the commercial bank sector swaps assets between Treasuries and reserves.

Active and passive quantitative tightening have similar implications but in reality, institutional features can influence the way the adjustment is transmitted across the different actors.

Current experience of quantitative tightening in the U.S.

In the next graph, I focus on the liabilities side of the Central Bank balance sheet highlighting the evolution of the reserve balances, the TGA account, and the Overnight Reverse Repo facility.

The interesting part of the evolution of the Federal Reserve Liabilities in recent times is the fact that since the SVB crisis (collapse of the Silicon Valley Bank) last March, reserves have not declined and have been relatively stable. On the other hand, the replenishment of the TGA has coincided with the decrease of the ON RRP balance from June 2023 onward. Thus, in the U.S. the reduction in the balance sheet has not been matched by a parallel decline in reserves. In the U.S. case, there are two components of the balance sheet that are crucial for understanding how reserve liabilities adjust. One is the TGA account, and the second one is the ON RRP.

ON RRP

To explain how all these components are connected we need to understand the role and the functioning of the ON RRP.

What is the ON RRP and why does it matter for understanding the evolution of the Federal Reserve balance Sheet?

The Federal Reserve's Overnight Reverse Repo (ON RRP) facility provides a floor for implementing its interest rate target (i.e., the federal funds rate) in abundant reserve environments.

The purpose of the ON RRP facility is to give participants in the short-term funding market a risk-free overnight option of lending to the Fed at the guaranteed ON RRP rate. ON RRP-eligible counterparties include banks, money market funds, primary dealers, and government-sponsored enterprises. Given the broader set of market participants, the ON RRP facility aims to make sure that other lending rates — like the fed funds rate — will be above the ON RRP rate.

The ON RRP facility usage steadily increased after March 2021 and reached a peak of $2.5 trillion at the end of 2022. It then decreased steadily starting from mid-2023 to a more recent balance of around $400 billion. The next graph illustrates its evolution:

Money Market Funds (MMFs) have been the main users of the ON RRP facility. MMFs are a type of mutual fund that invests in short-term, high-quality debt securities. They are designed to offer investors a safe place to invest in easily accessible, cash-equivalent assets. MMFs primarily invest in short-term, liquid instruments such as Treasury bills, commercial paper, certificates of deposit (CDs), and repurchase agreements. These funds aim to maintain a stable net asset value (NAV) of $1 per share, although this can sometimes vary. In this context, there are different types of MMFs.

-Government MMFs: Invest mainly in government securities like U.S. Treasury bills and repurchase agreements backed by government securities.

-Prime MMFs: Invest in a broader range of short-term corporate and bank debt securities, in addition to government securities.

-Tax-Exempt MMFs: Invest in short-term municipal securities and seek to provide income that is exempt from federal (and sometimes state) income taxes.

As of May 2024, the total assets under management (AUM) in U.S. money market funds have reached approximately $6.07 trillion. This includes $4.9 trillion in government funds, $1.04 trillion in prime funds, and $128.9 billion in tax-exempt funds (https://www.ici.org/research/stats/mmf).

The allocation of funds in the ON RRP facility has reflected the difficulty in finding short-term high-quality investments during most of the pandemic as funds have been directed towards MMFs.

Treasury issuance is also another important factor in affecting how ON RRP adjusts. At the broad level, Treasury issuances are split between bills (short-term securities with one-year max maturity) and coupons (standard Treasuries). Given stringent regulatory constraints, many MMFs are restricted to purchase bills but not coupons.

The reduction in the supply of Treasury bills (T-bills) is a potential factor driving the increased demand for the ON RRP facility. Before Covid-19, in 2019, the TGA averaged $290 billion. During the pandemic, the balance surged rapidly to $1.6 trillion by June 2020, with T-bills outstanding increasing from $2.56 trillion to over $5 trillion. The elevated TGA balance and T-bill supply were maintained until February 2021, then normalized through a reduction in T-bill supply.

It is worth noting that Basel III regulations limit the size and composition of an individual bank’s balance sheet pushing out deposits towards MMFs who place them in the ON RRP.

In general, adjustments in the TGA significantly influence the ON RRP through its impact on commercial bank reserves. When the Treasury increases the TGA by issuing more T-bills or collecting more tax revenue, it withdraws reserves from the banking system, potentially increasing the demand for the ON RRP facility as banks seek safe, short-term places to park excess cash. Conversely, when the TGA balance is reduced, reserves are released back into the banking system, which can decrease the demand for the ON RRP facility. This dynamic affects overall liquidity and short-term interest rates in the financial system.

Treasury Issuance and ON RRP

Consider the situation in which the Treasury issues bills (that can be bought by MMFs) as opposed to coupons or notes to repay its debt. So relatively to the case described under passive management, the treasury issues Bills to repay its debt.

The Treasury issues bills to repay its debt. Bills are bought by MMFs by withdrawing from ON RRP, rather than from commercial banks deposits (this implies that there is no change in commercial banks’ balance sheet). In this operation the Federal Reserve credits the TGA by the value of the bills sold to the MMFs, resulting in an ON RRP facility decrease by the same amount. There is no adjustment in reserves in this case. (red font operation).

The second leg is when the Treasuries uses its proceeds to repay the debt at maturity at the Central Bank.

In this case, the Federal Reserve withdraws the corresponding amount from the TGA to repay the Treasuries held at the Federal Reserve. (green font operation)

This case is interesting because it shows the role of the fiscal authority in influencing the adjustment on the liability side of the Central Bank balance sheet. By issuing bills, the Treasury can slow down reserve draining. The decrease in the asset side of the Federal Reserve balance sheet is matched by a decrease in the ON RRP facility as opposed to reserves. This is what many (@Concoda) have referred to all this as Stealth Quantitative Tightening.

Another way of looking at this is to say that the action of the Treasury (in terms of managing issuance) is counterbalancing the QT policy of the Federal Reserve in terms of managing reserves.

Implications for the yield curve and financial conditions

Another important implication of this policy is the potential effects on yield and risky assets in general.

One of the main mechanisms through which QT is supposed to work is related to the demand and supply of government bonds. A fall in the stock of bonds held by the central banks (via QT) implies that there will be a greater amount of government bonds available in the market, leading to an increase in the compensation required by investors to absorb more government bonds (i.e., the term premium rises). In other words, greater bond supply leads to lower prices.

Therefore, given that the term premium is one of the primary drivers of long-term term rates relative to short-term rates, a rise in long-term rates leads to a steepening in the yield curve.

But this last case shows that this mechanism might be muted in a context in which the Treasury issues bills (short-term debt). Indeed, in this case, the amount of government bonds available in the market will not change or will increase by a smaller amount than the QT operation leading to a smaller increase in the term premium and short-term rates being higher for longer leading to an inversion of the yield curve as opposed to a steepening.

In principle, we should observe a steepening under active QT and a more muted one under passive QT conditional on Treasury issuance.

Finally, the increase in the term premium under active QT can contribute to a tightening of financial conditions enhancing the transmission mechanism of monetary policy, especially in a context in which households and firms’ choices are directly affected by long-term yields.

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