Fed's Dual Move: Rate Cuts and Shrinking Balance Sheet

While everyone is focused on the Federal Reserve's potential interest rate moves in 2024 and beyond, there's another policy area that, though less exciting, is equally important. This area is the Fed's ongoing reduction of its balance sheet, known as quantitative tightening.

Despite the apparent contradiction of the Fed easing policy by lowering interest rates while tightening policy by reducing its balance sheet, the fact that there's no significant news from the Fed's balance sheet at the moment is good news for the markets.

The Fed's balance sheet is crucial for the implementation of its monetary policy. Banks hold reserves at the Fed and thus earn a risk-free return, which sets a floor for interest rates across the entire financial system. The Fed guides the federal funds rate - its main benchmark interest rate - through this mechanism, lowering its target range to 4.75% to 5% in September. Additionally, banks and other financial institutions can engage in "repurchase agreement" (repo) transactions, lending their holdings of U.S. Treasury securities to the Fed in exchange for cash to meet liquidity needs.

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In times of financial crisis or stress, the Fed can use its balance sheet to quickly inject cash into the economy and keep credit flowing. During the COVID-19 pandemic, the Fed took massive action, with its balance sheet swelling from about $4.2 trillion at the beginning of 2020 to nearly $9 trillion at its peak in 2022, as the Fed purchased large amounts of U.S. Treasury securities and mortgage-backed securities.

Since March 2022, the Fed has been reducing its balance sheet, which dropped to $7 trillion as of last week. Fed officials slowed this process in June. The Fed currently allows up to $25 billion per month in U.S. Treasury securities and $35 billion in mortgage-backed securities to mature without reinvesting the proceeds.

By allowing these securities to mature naturally without reinvestment, the Fed gradually reduces bank reserves, which means there is less cash available for banks to lend, potentially putting upward pressure on bond yields.

This seems contradictory to the Fed's rate-cutting moves. San Francisco Fed President Daly explained this contradiction as a matter of timing. She said at an event at New York University: "Interest rate adjustments are like a speedboat, while the balance sheet is like an oil tanker." She added: "The question is, are you willing to let the main policy tool wait for the oil tanker to turn?"

For Fed officials who want to describe interest rate adjustments as "normalization," reducing the balance sheet to pre-crisis levels also fits this logic. Fed Governor Waller believes that a pre-announced, slow, and steady reduction process is less likely to have a significant impact on the economy compared to the rapid expansion of the balance sheet during the financial crisis.

Waller said at Stanford University that he is not worried about a similar event in September 2019 - when the repo market temporarily froze during a quantitative tightening process, forcing the Fed to increase reserves. He compared the Fed's balance sheet actions to those of a firefighter: "When you encounter bad economic outcomes, you act like pouring water to extinguish a fire; after the fire is out, the water can be drained. And when the water is drained, the fire does not relight. This is the asymmetry of policy action."

Currently, according to a new indicator introduced by the New York Fed - Reserve Demand Elasticity, reserves are still "ample." This tool shows that changes in reserves have a minimal impact on the federal funds rate, meaning the Fed can comfortably continue QT into 2025 without unexpected economic or financial shocks.Policymakers hope to continue reducing the balance sheet until the reserve level falls to "ample"—a cash level determined by actual conditions. Although this goal may take some time to achieve, Federal Reserve officials are not concerned about it, believing that it can be reached without causing problems.