Federal Reserve Watch: Quantitative Tightening Continues

The Federal Reserve continues to reduce the size of its securities portfolio.

In the latest banking week ending Wednesday, March 18, 2023, the Fed’s securities portfolio fell by $66.7 billion.

This brings the total reduction in the securities portfolio since March 16, 2022, to $452.2 billion.

Here is the picture of this decline.

This picture of the Fed’s “quantitative tightening” is very consistent with the Fed’s efforts connected with “quantitative easing” that was used in the 2010s and the “quantitative easing” that was used to fight the spread of the Covid-19 pandemic in 2020 and 2021.

The Fed has used these “quantitative” methods to create wealth effects that will serve as the foundation for the economic results it hopes to receive.

The primary “wealth effect” the Fed hopes to achieve is the impact the Federal Reserve policy has on stock market prices.

In an attempt to stimulate the economy, the Fed hopes to support rising stock prices that will raise consumer wealth and lead to greater consumer spending.

In the attempt to constrain the economy, the Fed hopes to cause falling stock prices, thereby reducing consumer wealth and consumer spending.

Two aspects of the Fed’s efforts should be very clear from the chart.

First, the decline in the Fed’s securities portfolio takes place in small “chunks.”

Second, the decline is steady and extends over a lengthy period of time.

The decline needs to take place in small pieces so as not to create a major market movement that will disrupt the whole economy.

The decline must be steady and take place over an extended time so that investors will see that the Federal Reserve is really committed to rising…or, declining…stock prices.

The belief is that if the Fed conducted its efforts in a very erratic manner that investors would not get the appropriate signal. That signal is that the Fed is very intent in terms of what it is doing, and is pursuing this policy over the longer run.

Thus, the plan is for the Fed to achieve continuous, small movements in the portfolio.

As can be seen from the chart, the Fed is doing a very good job of this in the current effort.

Reserve Balances

This is not the “whole show,” however.

There are other factors impacting the Fed’s balance sheet that impact the amount of “excess reserves” that commercial banks hold.

On the Federal Reserve H.4.1 release, we find the line item “Reserve Balances with Federal Reserve Banks.” This is a close proxy to the excess reserves that exist in the commercial banking system.

The reduction in the Fed’s securities portfolio has been the major contributor to the decline that has taken place in the excess reserves of the commercial banking system.

But, there are several other factors that can impact reserve balances.

For example, the General Account of the U.S. Treasury can experience major changes due to tax collections or other factors impacting the Treasury’s cash position.

Since March 16, 2022, the General Account of the U.S. Treasury at the Fed has fallen by $244.0 billion. This decline releases monies from the Fed that must be made up in other ways.

One way is for the Federal Reserve to oversee an increase in reverse repurchase agreements.

Since March 16, 2022, reverse repurchase agreements at the Fed have risen by $638.7 billion. This increase reduces monies in the banking system.

So, a lot is going on with respect to the Fed’s balance sheet.

Reserve Balances with Federal Reserve Banks captures the movement in the Fed’s securities portfolio, but it also reflects all these other factors impacting the Fed’s balance sheet and the “excess reserves” of the commercial banking system.

Here is what has happened to reserve balances since the Fed began to tighten up its monetary policy last March.

One can see that the reduction of reserve balances has taken place in a steady fashion and for an extended period of time.

This is what the Federal Reserve is trying to do.

How Long?

The question is still, how long will this period of “quantitative tightening” last?

In the examples of quantitative easing conducted over the past decade, the stock market response to the Fed’s policy was also relatively steady.

In the case of the current quantitative tightening, the Fed has not been able to convince investors that it will really “stick” with the tightening policy.

Stock investors seem to continually be looking for a signal that the Fed is going to “pivot” from its quantitative tightening and ease up on the brake.

Take a look.

Not a very smooth decline at all.

The job of the Fed officials?

Their job must be to convince the investment community that they are going to stick by their plan and see it through until the back of inflation is broken.

How long that will take is anyone’s guess.

But, can the Federal Reserve hold out that long?

This is the ultimate question.

Keep tuned!