Investments

From Quantitative Easing to Quantitative Tightening

By Bud Kasper, CFP®, AIF®

March 3, 2022

From Quantitative Easing to Quantitative Tightening


Key Points – From Quantitative Easing to Quantitative Tightening 

  • The Federal Reserve Is Changing Its Game Plan
  • Investors/Retirees Need to Be Informed and Know What to Expect
  • What Are the Big Differences Between Quantitative Easing to Quantitative Tightening
  • Using History to Predict This Transition of Quantitative Easing to Quantitative Tightening
  • 6 minutes to read

Quantitative Easing Coming to An End?

At the Federal Open Market Committee’s January 2022 meeting, Federal Reserve Chairman Jerome Powell announced the Fed’s “intention” to end its quantitative easing program. The QE program was launched in March 2020 in reaction to the COVID-19 pandemic and its potential impact on the economy. The program was the biggest and broadest monetary-stimulus campaign in modern history.

As a result of their most recent meeting, the Fed is in the process of withdrawing its support for the U.S. economy. One of the first action items in their plan is the strong likelihood of shrinking its record balance sheet of more than $8.5 trillion. There are two likely maneuvers that the Fed can use in their effort to drive down today’s inflation. Year-over-year inflation is at 7.2%, which is the highest since 1982.

The Fed’s First Action Plan: Reducing Bond Buying

The Fed’s first plan of action started in December 2021. That’s when Powell and company reduced their monthly bond buying from $120 billion (which it initiated at the onset of the pandemic) to $60 billion per month. Bond buying drives the price of bonds higher, which helps force interest rates down and makes it less expensive to access money.

An action of this type helps stimulate economic activity and ushers in the prospects of an economic recovery. Since the Fed is now buying fewer bonds per month, it’s anticipated that they may stop their buying program altogether by the end of March. Bond returns will likely continue to feel the pressure, meaning it could be difficult to get decent returns. That’s especially true for traditional bonds. One might assume that investors should avoid bonds altogether.

However, bonds still represent portfolio diversification. Predicating on a specific type of bond can be safer approach for an investor to counter stock market volatility. It may also be more prudent to be in shorter maturity ranges—perhaps between one and five years. Cash flow counts in portfolio diversification, especially when the stock market is under pressure. Many types of bonds can still provide that benefit.

The Fed’s Second Action Plan: Reversing Its Current Policy on Interest Rates

The second tactic of choice is for the Fed to reserve its current policy on interest rates. Instead of keeping them at our current historic low of 0.25%, which is where it also was a year ago, they can raise them. This is called quantitative tightening.

In simple terms, the Fed funds rate is the interest rate at which banks and other depository institutions lend money to each other. That usually happens on an overnight basis. The law requires banks to keep a certain percentage of their customers’ money on reserve with the banks earning no interest on it. Consequently, banks try to stay as close to the “reserve limit” as possible without going under it. Banks lend money back and forth with each other to maintain that proper level.

In a nutshell, the Fed funds rate is used to control the supply of available funds (money) to impact inflation and other interest rates. Raising the Fed funds rate makes it more expensive to borrow. That lowers the supply of available money, which in turn increases short-term interest rates and slows the inflation rate.

Lowering the rate has the opposite effect. Bringing short-term interest rates down makes it less expensive to borrow money. That serves as a stimulate to the economic growth. Raising the Fed funds rate does the opposite, which is what we’re about to witness this month.

What About the Impact on the Housing Market?

The corollary to this is the housing market. Over the past couple of years, the Fed started driving down interest rates through quantitative easing for the past couple of years to prevent COVID from potentially slowing the economy. People looking to buy a new home could now borrow at some of the lowest interest rates in housing’s history.

These lower borrowing rates fostered a surge of home buyers, which allowed sellers to ask more for their homes. And, well, you know the rest of the story. As the Fed starts to raise rates, I believe we’ll slowly start to see the beginning of the opposite of this phenomenon. It will be guided by how fast the Fed raises rates.

The Fed’s Strategies with Matured Bond Money

Once the Fed starts raising rates, there is one more tactic they can use that involves matured bond money. When a bond from the Fed’s $8.5 trillion portfolio reaches its maturity date, the Fed could use that matured bond money to buy more bonds or let it run off. One thing to keep in mind, though, is that using the matured bond money wouldn’t reduce the Fed’s balance sheet.

Understand that that Federal Reserve effectively “created” the money it used to buy the bonds out of thin air in the first place. Now, the Treasury department “pays” the Fed at the maturity of the bond by subtracting the sum from the cash balance sheet. Doing so effectively makes the money disappear, which then reduces the number of bonds in the Fed’s portfolio. This is all referred to as quantitative tightening.

A Flashback to the Last Transition from Quantitative Easing to Quantitative Tightening

The last time that the Fed transitioned from quantitative easing to quantitative tightening, they kept their balance sheet steady for about three years AFTER finishing the taper through the reduction of the Fed funds rate. The Fed did that by using the money from maturing bonds to buy replacements. They didn’t turn to quantitative tightening until they had raised its interest rate target range from near zero to 1%. It then went to 1.25%. This is a sequence that many analysts believe we’ll see this time as well.

How Many Fed Funds Rate Hikes Could We See?

From the first Fed taper at the onset of COVID-19 to today’s anticipated rate hikes, we are entering the early stages of quantitative tightening. Again, we have already witnessed the decrease of monthly bond buying from $120 billion to $60 billion. There’s a 70% chance that we’ll see a 0.25% increase in the Fed funds rate after March 16. There’s a 30% chance that we could a 0.5% increase. Many economists are betting that there will be five Fed fund rate increases in 2022. However, there have been estimates that we could see as many as seven.

In June 2021, I told my partner, Dean Barber, on America’s Wealth Management Show that the Fed was already behind on deciding to raise rates. I thought then that they should start raising rates in November or December of 2021. Now that we’ve passed that, I believe that my prediction was correct.

Borrowing Costs Bound to Rise with Transition for Quantitative Easing to Quantitative Tightening

As the shift from quantitative easing to quantitative tightening takes money out of the financial system, borrowing costs are bound to rise. Just as quantitative easing drove interest rates down, quantitative tightening is expected to put pressure on the financial as they rise. As interest rates rise, the price of some bonds will fall. Furthermore, stocks most likely will be under increased pressure as well.

Looking at Some Lessons from the Past

In June 2017, former Fed Chairwoman Janet Yellen said that quantitative tightening will be “something that will just run quietly in the background over a number of years. It will be like watching paint dry.” Powell, who was Yellen’s successor, described quantitative tightening as a program that was on “automatic pilot.”

However, after the S&P 500 tumbled almost 16% in a three-week period in December 2018, the Fed blinked. They abandoned rate hikes in January 2019 and announced the phasing out of quantitative tightening in March 2019. So, did it work?

In September 2019, interest rates surged into the repo market, which is a key source of short-term funding. That prompted the Fed to inject short-term liquidity in its first such operation in a decade. The following month, policy makers said they’d ramp up purchases of Treasury bills to maintain an ample supply of bank reserves.

Most people have probably forgotten about the famous 2013 Taper Tantrum. That came about because of low reserves and higher foreign currency debt among emerging economies. The result was a surge in U.S. Treasury yields. Could that happen again? It’s highly unlikely this time around, but we shouldn’t forget the lessons of the past.

What Else Could the Fed Have Up Their Sleeve?

So, does the Fed have an additional plan of action as we embark on a potential series of rate increases? The Fed has new tools it can use to avert at least some short-term strains in the financial markets. Last year, it introduced the Standing Repo Facility, which can provide as much as $500 billion in cash overnight to the banking system. A separate facility offers dollars to other central banks around the world.

The Federal Reserve Bank of New York can also mount unscheduled domestic repurchase agreements. A sustained spike in use of the facilities could serve as a signal of trouble ahead. U.S. fiscal policy is tightening as pandemic relief spending winds down. With the trajectory and impact of the pandemic being difficult to predict, there could still be other strains that combine to hit the financial markets.

Moderation Is Key

Moderation may very well be the key takeaway. A transition from suspicion and guesswork to transparency within the Federal Reserve began under Ben Bernanke’s watch. Today’s FOMC appears to be following the same track. It’s true that the markets hate uncertainty and that tackling our nation’s financial issues is an important but difficult task. But as former Treasury Secretary Lawrence Summers said, “This time is different” are four very dangerous words. We don’t think so.

If you have questions about the transition of quantitative easing to quantitative tightening and how the Fed raising rates could impact your unique financial plan, you can schedule a 20-minute ask anything session or a complimentary consultation with one of our financial advisors. We are happy to meet with you in person, by phone, or virtual meeting.

Bud Kasper, President, Lee’s Summit Office


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The views expressed represent the opinion of Barber Financial Group an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Barber Financial Group does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.