During the pandemic, the Fed expanded its balance sheet by $5trn, and the Fed is now shrinking it by $95bn every month with $60bn in Treasuries and $35bn in mortgages, see the chart below.
The implications for markets of QT are the opposite of what they were for QE. The idea with QE was to lower rates, boost equities, and narrow credit spreads. With the Fed now in tightening mode, the idea with QT is to raise long rates, lower equities, and widen credit spreads. Such a tightening in financial conditions helps increase the costs of capital and ultimately slow down inflation, see also this Fed paper, which finds that shrinking the Fed balance sheet by $2.5trn is equivalent to increasing the Fed funds rate by half a percentage point.
There are a lot of opinions in financial markets about the effects of QT, but the Fed’s view is clear: Even if the effects of QT are the opposite of QE, the negative effects on the economy and markets of QT are smaller than the positive effects of QE simply because QE normally comes quicker and bigger than QT. In other words, the fact that QT is drawn out over a much longer period than QE is spreading out the negative effects over a longer period.
The bottom line is that the Fed, with rate hikes and QT, is tightening financial conditions, and the Fed’s intentions are clear: higher long rates, lower equities, and wider credit spreads. But because these effects are spread out over a longer period than when the Fed is doing QE, the negative effects of QT on markets and the economy are smaller than the positive effects of QE.
For more, see these Fed papers here, here, here, and this paper by Caballero and Simsek.
Source: FRB, Haver, Apollo Chief Economist
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