Interest rate changes are not the only tool in the Federal Reserve’s toolbox

For about two years, the Federal Reserve has tried to cool inflation by setting and keeping interest rates high. But while the federal funds rate may be the most famous tool in the Fed’s monetary policy toolbox, it’s not the only one.

Moreover, for about two years, the Federal Reserve has been engaging in what is known as quantitative tightening: allowing trillions of dollars of mortgage-backed securities and government debt to flow off its balance sheet.

Quantitative tightening, or QT as the cool kids call it, has also helped raise interest rates and lower inflation. So now that Chairman Jay Powell is considering a rate cut in September, is it time to put QT back in the toolbox?

When the pandemic hit, the Federal Reserve refreshed its emergency playbook from the 2008 financial crisis and devised Ben Bernanke’s “Hail Mary” strategy: buy tons of government bonds and mortgage-backed securities to keep the economy afloat.

“So we went from $4 trillion to $9 trillion. We more than doubled the (Fed’s) balance sheet in response to the pandemic,” said Olu Sonola, head of economic research at Fitch Ratings in the U.S.

It was quantitative easing, and it worked. Maybe too well.

In 2022, faced with rising inflation, the Federal Reserve began quantitative tightening: it allowed the withdrawal of up to $60 billion of Treasury bonds from its balance sheet each month.

“As the market sells off Treasury assets, there is downward pressure on prices,” Sonola said.

And growing pressure on interest rates on all types of loans, from mortgages to auto loans.

Fast forward to the summer of 2024, and the Fed is still taking quantitative action to tighten monetary policy, although it may appear that it will look to cut interest rates soon.

“So this is counterintuitive. It seems to be going in opposite directions,” said Tiffany Wilding, an economist at Pimco, a large bond investment firm.

But Wilding said the Fed’s shrinking balance sheet doesn’t necessarily undermine efforts to ease financial conditions. It’s just another step the Fed is taking to normalize monetary policy.

“The Federal Reserve believes that the continued reduction of the central bank’s balance sheet returns the balance sheet to a neutral value,” Wilding said.

The Fed has slowed the pace of quantitative tightening this year. But Deutsche Bank’s Matthew Luzzetti said there’s another reason the Fed hasn’t stopped selling bonds altogether, for now.

“The smaller the balance sheet is today, the greater the capacity to respond to shocks or crises in the future,” Luzzetti said.

I don’t want to worry us or anything.