The Fed raises interest rates, but there’s another tool it hopes will help squash inflation and deflate market bubbles

  • The Fed has raised interest rates this year, but that’s only half its approach to fighting inflation and taming frothy markets.
  • Quantitative tightening aims to absorb excess liquidity from the market, combat inflation and deflate bubbles.
  • Experts say there is a chance it will go too far, but the Fed can avoid a crisis if it eases QT gradually.

Inflation weighed on markets throughout the year, as the Federal Reserve raised interest rates by more than 300 basis points in an effort to rein in higher rates.

Strict and historic price increases are only half of his approach, and another tool the central bank has been using recently to help crush inflation and deflate market bubbles that have formed as a result of years of easy monetary policy.

Unfortunately for investors, this tool is also set to influence the stock and bond markets, perhaps more than the Fed’s rate hikes. Such a massive change in liquidity conditions has raised fears that quantitative tightening – the runoff of the Federal Reserve’s $9 trillion balance sheet – could end in a market crash.

Here’s how two experts explain the Fed’s QT system, and why it’s a delicate balance between fighting inflation and keeping markets afloat.

What is quantitative tightening and what does reduced liquidity mean?

When the Fed takes quantitative tightening, it reduces the size of its balance sheet. These are assets raised by the central bank, such as long-term government bonds, that eventually mature and allow the Federal Reserve to recover the capital on those bonds. Once they mature, the Fed can either reinvest that money, or it can reduce the size of its balance sheet simply by letting the bonds “run out.” During quantitative tightening, the Fed chooses not to reinvest.

This is slightly different than if the Federal Reserve were actually going to sell the bonds on its balance sheet to the market, but it has a similar effect in driving prices higher.

The Fed removes about $95 billion in Treasuries and mortgage papers from its balance sheet each month. Essentially, this lowers the demand for long-term bonds, which increases long-term real interest rates.

What is the QT effect?

The Fed hopes it can help reduce inflation. When long-term interest rates rise, it causes asset prices to fall, slowing inflation. Higher rates also encourage households to save more, which discourages the type of consumption or investment that overheats the economy and stimulates inflation.

Does it affect stocks?

Similar to higher interest rates, which can affect corporate profitability and lead to lower stock prices, QT can have a negative impact on stocks.

Remember, QT drains liquidity from the markets by removing a secured buyer for massive amounts of debt securities. Removing that much liquidity from the market inevitably has a ripple effect, and bubbles will bubble up like the meme frenzy that has gripped markets during the pandemic.

According to Amir Kermani, an economist at the University of California, Berkeley, this is also because when long-term interest rates on bonds rise, investors will want to switch from stocks to long-term bonds.

So, no more stock meme frenzy?

Given that quantitative tightening and higher interest rates will likely put a lid on MIM stocks and asset speculation in general, RBA analyst Michael Kontopoulos told Insider.

But it’s not just about quantitative tightening.

“It would be too simplistic to be limited to that,” Kontopoulos said. He noted that a lot of pandemic-era stimulus money had made its way out of savings, which was a major driver of interest in stocks. The Fed’s rate hike has also dampened the appetite for stocks this year by increasing short-term interest rates.

With three-month government-guaranteed Treasuries yielding over 4%, why risk money in a stock market that is down 20% year-to-date?

When will Qt end?

Kermani says quantitative tightening cannot last forever, and the Fed will likely need to start slowing the pace of its balance sheet reduction. This is largely because the money off the balance sheet mostly comes from excess reserves, which banks use to meet their liquidity needs.

Kermani estimates that the financial system may not be able to withstand the drop in excess reserves of banks to less than $2 trillion, which could lead to the Fed stopping QT sometime in late 2023. Slow the pace of quantitative tightening.

Will stocks go up after Qt ends?

There is hope for a 2023 rally, according to Bank of America, which says that even a shift from quantitative tightening to “patching” would spur equities.

Though, other experts have their skepticism regarding the tailwinds provided by the QT end.

“The quantum dance will have a temporary effect,” Kontopoulos said. “Our research shows that the earnings slump is about to start and will only get stronger in 2023.”

He noted that stocks were largely affected by the Fed’s “liquidity bubble burst” in the first six to nine months of this year, but Fed policy will have less impact on stocks later as markets shift their focus to corporate earnings.

“I think the next stage of the race to the downside in stock prices will be driven more by the lack of earnings growth than it will be by anything the Fed does.”

Could the Federal Reserve tamper with this?

Kermani says quantitative tightening will not necessarily cause stock prices to crash — as long as the Fed gradually reduces its portfolio. But he thinks it would be a mistake to abruptly stop the quantitative tightening process altogether at this point.

“It is a huge mistake for the Fed to change its mind out of fear of what will happen to stock prices. We don’t want to live in a world where the Fed is responsible for insuring the stock market. So I think some gradual adjustment of market prices isn’t really bad.”

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