A client reached out with a question on a line in an article released after Wednesday’s Fed meeting – asking what a certain sentence was saying. Here was the quote: The Fed said it would soon end a 3 year effort to reduce the size of its $6.6 trillion balance sheet in a bid to ease strains in short term borrowing markets. Great question as this sentence is VERY confusing!

Before answering this question, let’s revisit the two main tools the Federal Reserve has access to in order to achieve it’s dual mandate of price stability (manage inflation) and full employment (manage labor markets).

The most commonly known tool is moving the Fed Funds Rate up or down. The lesser known (or at least the lesser understood) tool is management of the Federal Reserve’s balance sheet. This balance sheet management is known either as quantitative easing or quantitative tightening. This is the tool the quote – and this post – will focus on.

The Federal Reserve maintains a portfolio of investment securities (comprised of US issued mortgage backed securities and treasuries of varying maturities). This collection of bonds is known as “the Fed’s balance sheet. Depending on what is happening in the economy, the Fed can either buy more treasuries in the open market (thereby injecting cash into the system) or sell and/or allow their current holdings to mature/roll off and not purchase more (thereby removing liquidity from the system).

Quantitative Easing (QE) is the term used when the Federal Reserve is buying government issued fixed income securities (again, treasuries and mortgage backed securities) and building up its balance sheet. In simplest terms, the Fed creates new money (increases the money supply) and gives it to commercial banks in exchange for the the bonds. The banks are then able to lend the funds to businesses/consumers, thereby spurring economic growth and investment. This added liquidity (and lending) “eases” monetary conditions and is used as a tool (along with the lowering of the fed funds rate) in times of economic stress.

Quantitative Tightening (QT) is the term used when the Federal Reserve allows its securities to mature without replacing/rebuying them (or outright sells them), thereby reducing the size of its balance sheet. By not repurchasing securities and/or by selling them, the Fed is in effect taking cash out of the economy as banks step up and buy them if the Fed does not. This reduces liquidity, thereby reducing banks’ lending ability, which restricts (or tightens) monetary conditions. QT is used to normalize the Fed’s balance sheet (so easing can be an effective tool in the future) and also as a way to combat inflation (by taking money out of the system). QT is often used in connection with increases in the Fed Funds rate in times of excess or runaway inflation.

Now, back to the sentence from an article released after this week’s Fed meeting:

The Fed said it would soon end a 3 yr effort to reduce the size of its $6.6 trillion balance sheet in a bid to ease strains in short term borrowing markets

In the immediate wake of COVID, the Federal Reserve was trying to spark economic growth in the face of a global economy that had come to a screeching halt due to the pandemic. To do so quickly, they cut the federal funds rates to zero and began an aggressive Quantitative Easing program to inject liquidity into the markets. This approach worked great – until we found the US economy awash with cash, not only from monetary actions (ie: QE and zero interest rates) but also from the massive fiscal stimulus (in various forms ranging from stimulus checks to PPP loans, etc). In an effort to stop inflation and normalize its balance sheet, the Fed pivoted to QT in June 2022. This is the “3 year effort” the article is referring to.

In June 2022, when the most recent round of QT began, the Fed’s balance sheet stood at almost $9 trillion and inflation was stubbornly high. At that time, the Fed started to let its holdings roll off and as a result, its balance sheet began a steady decline to its current $6.6 trillion level. During this time, the central bank has allowed up to $5 billion in Treasuries and up to $35 billion in mortgage-backed securities to mature monthly without reinvesting the proceeds.

This more than $2 trillion in bonds the Fed allowed to mature – without replacing them – pulled money out of the financial system. This is a bit complex but here are the mechanics… When the Fed doesn’t buy the securities, banks step in to buy that debt, leaving them with less cash reserves (as they pay cash for the securities). This leaves banks with less cash to lend, but also reduces the amount of money banks keep in reserves at the Fed. Less money in the system puts upward pressure on short-term borrowing costs (ie: strain in short term borrowing markets).

The Fed has always said it would stop QT when it could sense banks were no longer “awash with cash.” The Fed noted there are signs this is now true and as a result, announced it will end QT for the time being. By stopping QT, the Fed said it will replace treasury securities are they mature moving forward (but continue to let mortgage securities run off), thereby putting some level of liquidity back into the banks, which will then increase Fed reserves, lowering short term borrowing rates, and increasing bank lending – all of which will lessen the strain in the short term borrowing market.

Monetary policy – whether it’s adjustment of the Fed Funds rate or adjustments to the Fed balance sheet – are powerful tools that need to be used in careful harmony with one another to achieve the dual goals (stable prices and maximum employment). Time will tell if the ending of QT – and lowering of the Fed Funds rate – will work as we end 2025 and beyond