Tapering QT Will Be About Easing, Not Prolonged Tightening (May 1, 2024)

A slowdown in the pace of balance-sheet runoff may come as inflation fears appear overblown and growth cracks spread

By Lisa Beilfuss
May 1, 2024

When the Federal Reserve announces plans to taper quantitative tightening, officials and strategists will say that doing so enables QT for longer and will thus lead to a bigger unwind of massive pandemic-era bond purchases. 

That interpretation probably won’t be right. In reality, the slowing of QT will be tantamount to the beginning of the easing cycle, which will be necessary sooner than many expect.

After $5 trillion in quantitative easing more than doubled the Fed’s portfolio, the Fed has let roughly $1.5 trillion in Treasuries and mortgage-backed securities roll off its balance sheet. The Fed’s portfolio is still equivalent to about 27% of U.S. gross domestic product. Many on Wall Street expect the Fed to halve its runoff cap for U.S. Treasuries to $30 billion a month, starting June 1. (Runoff of mortgage-backed securities, or MBS, is already limited by relatively high interest rates, so many expect the Fed’s MBS cap to be held at $35 billion a month).  

The result of QT is a loss of bank reserves and deposits, which reduces liquidity in the banking system and weighs on financial markets. When the Fed met in March, the "vast majority" of Fed officials said it was prudent to “fairly soon” begin slowing the pace of balance-sheet runoff. The rationale included future declines in overnight RRP balances, or the amount of cash parked at the Fed overnight reverse repo facility. The Fed uses the RRP to set a floor for the fed funds rate, and the facility is often considered a proxy for overall bank reserves and system-wide liquidity. 

What is more, “bank reserves have had a suspiciously strong relationship with stock market performance in the QE/QT era,” says Piper Sandler’s chief global economist Nancy Lazar, as abundant reserves have kept financial conditions easy and supported stocks. This relationship didn’t exist before the introduction of quantitative policies, she says, noting that bank reserves dipped in April. 

Because slowing the pace of balance-sheet rundown would keep bank reserves higher and long rates lower, officials such as Dallas Fed President Lori Logan have said that tapering QT sooner would reduce the likelihood the Fed would have to stop QT prematurely.

But that argument is “hocus pocus,” says Stephen Miran, fellow at the Manhattan Institute and former senior advisor at the Treasury Department. “QT is monetary policy and reducing it is an easing of monetary policy.”  

Effectively beginning the easing cycle now seems awkward, to say the least. Inflation data have been consistently hot since the start of the year. The Fed’s preferred measure, the core personal consumption expenditure index, is running a full point below the core consumer price index. Yet the core PCE was still up 2.8% in March from a year earlier, nearly a point above the Fed’s stated target. 

The Employment Cost Index dealt the latest blow when it rose a faster-than-expected 1.2% in the first quarter of this year versus the fourth quarter of last year. The ECI, which includes non-wage compensation and benefits, is considered the gold-standard metric of worker pay because it is the broadest measure of how much an employee costs.

But it is worth digging into the data. Quarterly inflation numbers appear front-loaded, if the monthly PCE figures are a guide. Omair Sharif of Inflation Insights notes that the core PCE for January was revised up to 0.5% from 0.45%, while February was revised up just slightly to 0.27% and March came in at 0.32%.  

And some have poked holes in the latest ECI. Sharif says sectors that account for 61% of total employment either decelerated or were unchanged in the first quarter. The ECI combines hours worked and wages, and Michael Green, chief strategist at Simplify Asset Management, notes that the number of hours worked fell in the first quarter. Hours worked is considered a leading indicator because employers often cut hours before conducting layoffs. Economists at Goldman Sachs say compensation growth was again disproportionately strong among unionized workers–what they say is a lagging indicator because union workers' contracts adjust less frequently. 

Now take a step back. Contrary to conventional wisdom, economist Jim Paulsen says we simply lack the “policy fuel” necessary for inflation to again become problematic. He uses an indicator called Total Policy Stimulus, or TPS, which combines what he calls the four major policy tools: monetary policy, fiscal policy, the U.S. dollar, and bond yields. The TPS adds annual money supply growth and the ratio of fiscal deficit spending to GDP, then subtracts the annual change in bond yields and the annual percent change in the U.S. dollar. 

Since mid-2023, Paulsen says “fiscal juice” has declined by about 2.5%. That is as both bond yields and the dollar have tightened in recent months. “Inflation has again been receiving a full dose of restrictive force,” says Paulsen, warning that the TPS is about to begin declining again this summer. 

While Paulsen says the relationship between inflation and the TPS indicator is far from perfect, it has done a good job indicating the level and direction of inflation one year in advance. Based on the TPS, Paulsen says he thinks the annual CPI inflation rate is headed between 0 and 2% in the next year.

Now consider some recent disappointing growth markers alongside Paulsen’s TPS indicator. The Treasury said it must borrow more than had been expected in the second quarter because tax receipts have disappointed. The Conference Board’s measure of consumer confidence fell to the lowest level since July 2022. 

The weakening NFIB small business survey has suggested much slower job gains from the second quarter onwards, and the S&P PMI employment index is now telling the same story, says Ian Sherpherson of Pantheon Macroeconomics. He notes that while the NFIB leads by about four months, the S&P PMI jobs measure is more of a coincident indicator. All this is as a host of companies, such as Starbucks and McDonald’s, report flagging consumer demand.

One final point: Greg Barker of the financial newsletter Concoda suggests QT–launched in June 2022–is only just starting to bite. The idea is that until recently, Treasury Secretary Janet Yellen has been offsetting the impact of balance-sheet reduction via easy-to-absorb short-term bill issuance. At the same time, a big Treasury General Account drawdown pushed bank reserves back into the system, adding liquidity and pushing stocks higher. 

But the tide is now turning, Concoda says. Yellen is now issuing more Treasuries with longer maturities and more duration risk, potentially forcing buyers to sell riskier assets to counteract the increased risk they are bearing. “Tighter quantitative tightening has been activated, unleashing a stealth tightening effect on markets,” says Concoda.

Market implications of tighter QT, mounting growth cracks, indications that inflation isn’t looking quite as bad as some fear, and a Fed that has a tolerance for above-target inflation all support the conclusion that monetary policy easing may start sooner than later. Regardless of how officials frame it, such easing may first arrive in the form of tapered QT– which is at least as important as interest-rate cuts upon which most are focused.