The Fed is about to go full throttle on QT. Do not be afraid.
Critics of QE may downplay its effect on the economy, but it is generally accepted that the policy has boosted financial asset prices, especially in times of market stress. Unfortunately, forecasting stock prices isn’t as simple as overlaying a graph of the size of Fed balance sheet assets on the S&P 500 Index.
Besides QE and QT, other factors directly affect economic liquidity. Incorporating inputs such as the Fed’s Reverse Repurchase Agreement Facility, which allows financial institutions to store excess cash with the central bank, and the General Treasury Account, which functions as the government’s current account at the central bank. These elements create a more robust liquidity gauge that better explains recent stock market movements, while providing an improved framework for predicting QT effects.
When the Covid-19 pandemic hit, the Fed embarked on an unprecedented QE program, buying about $120 billion in bonds each month. At the same time, the government enacted the biggest fiscal stimulus in decades, which injected trillions of dollars into the economy. The liquidity created by QE and fiscal stimulus was so great that commercial banks no longer wanted deposits from large institutional customers because there were not enough safe assets available for purchase.
To remedy the situation, the Fed expanded its reverse repo program, which involved the Fed providing high-quality collateral with the promise to redeem it in a certain number of days at a higher price. Reverse repos are a cash-draining operation, much like QT. They both imply that the Fed decreases the amount of cash in the system by increasing the amount of bonds. Usually, the Fed only engaged in repurchase transactions with primary dealers, but the need to absorb additional liquidity was so great that it expanded the list of eligible counterparties to include mutual funds. investment and other non-traditional accounts.
The liquidity glut is evident in the growth of the reverse repo transaction to its current size of $2.18 trillion, from virtually nothing before the pandemic.
Reverse repos are just one example of a Fed operation that affects liquidity, but there are others, including those from other branches of government. The General Treasury Account is one that has gained considerable importance over the past decade. In the past, when the government issued fixed income securities and levied taxes, it almost immediately distributed the funds for these efforts. Because of this, the TGA rarely had a balance.
In the era of Covid, however, there have been times when the TGA has grown to previously unimaginable levels, reaching nearly $1.8 trillion by mid-2020. Increases in TGA have the same effect as QT. Bonds are issued and cash withdrawn from the financial system, but the money is not distributed in the economy. This is a cash out operation.
By combining the size of the Fed’s balance sheet with the amount of outstanding repos and the TGA balance, we can create a liquidity indicator that explains stock price movements better than the Fed’s balance sheet alone.
There are concerns about the expected increase in QT on equity prices, but the unique situation with the large reverse repo balance could mitigate any potential effect. If the Fed had securities on its balance sheet that matched the maturity profile required by institutions performing reverse repos, it could sell an amount equal to the total reverse repos balance to those institutions, thereby reducing the need for reverse repos. and resulting in no change in the financial or real economy. Although there may be a duration mismatch in the type of assets demanded, an actual withdrawal of cash is not the problem.
In addition to that, the actual amount of monthly QT is not so important. Given that the reverse repo balance is $2.18 trillion and the Fed is expected to reduce its balance sheet by $95 billion per month, it would take almost two years to work on the repo only through QT. Moreover, the variability of the TGA balance shows that the economy can handle the anticipated withdrawal of liquidity. From the end of November 2021 to April 2022, the TGA increased by $816 billion. That equated to a QT of $163 billion per month, well below the predicted and well-telegraphed increase next month.
Although throughout history there have been a few times when central banks have successfully reduced assets from their balance sheets, this is an unusual time. The extraordinarily high reverse repo balance shows the true extent of the additional liquidity in the financial system. So, as QT unfolds, it will be important to monitor whether the reverse repo balance decreases and how quickly. The QT numbers look large, but compared to the fluctuations in the TGA account and reverse repos, the predicted increase is rather modest.
More other writers at Bloomberg Opinion:
• Powell must back his words with actions: Bill Dudley
• Powell can’t count on a labor market miracle: Jonathan Levin
• What the Hawks didn’t get in Jackson Hole: Daniel Moss
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Kevin Muir is a former institutional equity derivatives trader who now writes the MacroTourist newsletter.
More stories like this are available at bloomberg.com/opinion