Federal Reserve Watch: Quantitative Tightening Continues

The US Federal Reserve building in Washington DC

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

Policy-wise, this is about all that matters now.

The securities portfolio declined by only $4.1 billion in the last banking week, but since the quantitative tightening began, the securities portfolio has declined by just under $190.0 billion.

Securities Held Outright

Securities Held Outright (Federal Reserve )

The Fed’s original plan was to see its securities portfolio decline by about $95.0 billion every month into 2024. This original plan suggested that the program would continue until the securities portfolio had fallen by about $2.2 trillion.

This program of quantitative tightening is consistent with the two times the Fed imposed quantitative easing on the banking system.

For example, to fight the spread of the Covid-19 pandemic, the Federal Reserve conducted a quantitative easing program where the Fed bought $120.0 billion of securities every month between the spring of 2020 and the end of 2021.

The current program of quantitative tightening is very important because it is the “backbone” of the Fed’s effort to fight inflation. Consequently, the Fed’s effort is highly dependent upon the Fed sticking with this plan.

The problem the Fed is facing right now is that investors seem to be very doubtful that the Fed will continue this program.

Many investors believe that the Fed will have to “pivot” from the plan. The success of the plan is dependent upon stock prices falling.

Investors do not believe that the Fed will continue to see its portfolio decline in the face of a rapidly declining stock market. The Fed will find a way to “back out” of the quantitative tightening.

The reason? Well, during both the previous rounds of quantitative easing, the ones under Fed Chair Ben Bernanke and the one under Fed Chair Jerome Powell, the leaders of the Fed always seemed to want to err on the side of monetary ease. They did not want to be caught being responsible for creating the environment for a policy mistake.

Many investors feel that this attitude is being carried on into the current situation. These investors believe that the Fed would like to defeat inflation, but are very concerned about not setting off an unintended stock market collapse by being overly tight.

This is the explanation of why the stock market is so volatile at this time. The Fed is tightening up, but many in the investment community believe that the Fed will “back off” from the quantitative tightening “pivot” to a policy position that is less extreme than the current one.

The performance of the stock market yesterday was an example of the volatility that is currently present within the investment community.

New information on inflation came out in the morning. The S&P 500 Stock Index, upon getting the information on inflation, dropped by about 80 points in the morning before stock prices turned around and ended up by about 90 basis points for the day.

Quite a ride.

But, Fed Chair Jerome Powell and the rest of the leadership of the Federal Reserve have remained, publicly, very committed to sticking with the quantitative tightening program.

This is why, I believe, it is so important to watch the Federal Reserve balance sheet data during this time period.

We must know whether or not the Federal Reserve is sticking to its quantitative tightening objectives.

This is where the game is right now.

Bank Liquidity

Excess reserves in the commercial banking system continue to decline as the securities portfolio of the Federal Reserve continues to be reduced.

Excess Reserves

Reserve Balances with Federal Reserve Banks (Federal Reserve)

Here we use the balance sheet line item “Reserve Balances with Federal Reserve Banks” as a proxy for the excess reserves in the banking system.

As can be seen, the excess reserves in the banking system have declined since the Fed began the tightening on March 16, 2022.

And, it is this tightening that is supporting the rise in the Federal Reserve’s policy rate of interest.

Note that the Federal Open Market Committee, the FOMC, made the “first move” in this policy round at its meeting on March 16, 2022.

Federal Funds Rate

Effective Federal Funds Rate (Federal Reserve)

The Federal Reserve is, of course, underwriting this rise in the effective Federal Funds rate by overseeing the decline in the excess reserves in the banking system.

This, of course, will be the pattern going forward.

The Federal Reserve will continue to oversee the reduction in the size of its securities portfolio. These reductions will continue to reduce bank liquidity. And, the reduction in bank liquidity will continue to support the rise in the Fed’s policy rate of interest.

This is the program for the future.

The most important of these efforts is the first one mentioned above…the reduction in the size of the securities portfolio.

That is why we need to keep our eyes on how the Fed is managing this reduction.

The Future

Given the data on inflation released yesterday, Mr. Powell and the Fed certainly have information to back up further increases in the Fed’s policy rate of interest.

Expectations have risen that the Fed will introduce another 75 basis point increase in its policy rate of interest following the next meeting of the FOMC, which takes place on November 1 and 2.

Furthermore, expect the size of the Fed’s securities portfolio to continue to decline through this period so as to cause bank excess reserves to decline further, supporting the rise in the Federal Funds rate.

That will take the effective Federal Funds rate to 3.83 percent.

Connected with this is the expectation that the stock market will fall further into “bear” country.

But, who can fully count on the stock market to behave rationally?

We are in a period of radical uncertainty, and we are also facing a period of political decision-making. High market volatility it seems, will surround the events of the next three weeks.

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