At the conclusion of its regularly scheduled Federal Open Market Committee (FOMC) meeting, the Federal Reserve announced that it was leaving the Federal Funds rate unchanged but was going to begin the process of reducing the size of its balance sheet. When the Federal Reserve was increasing the size of its balance sheet, the financial markets called the process “Quantitative Easing”. So, it is only fair that as the Federal Reserve is starting to shrink its balance sheet we should call that “Quantitative Tightening”.
The Federal Reserve has been extremely active in communicating to the financial markets that Quantitative Tightening is no big deal. Federal Reserve officials have emphasized that they are going to do this very slowly and Federal Reserve Chairperson Janet Yellen went so far as to characterize the process as being akin to watching paint dry. The financial markets and the Federal Reserve both argue that Quantitative Tightening is going to be slow enough that it will not disrupt the bond markets. My only caution is that, since this has never been done before, we cannot assume that we know exactly what will happen. Theory is one thing, reality is often something different. One of the sayings in the financial markets is “when everyone thinks that one thing will happen, something else usually happens”. What the “something else” might look like is unknown at this point because human psychology is involved. Human psychology is clearly a factor in how financial markets behave, and human psychology is something that cannot be precisely quantified.
The Federal Reserve plans to start Quantitative Tightening by shrinking its balance sheet $10 billion a month and then it will gradually increase the pace over the next several years. Even though this is a very gradual process, make no mistake that this is still an action from the Federal Reserve that is more restrictive than its current policy. Federal Reserve officials have gone to great lengths to assure the financial markets that they are not tightening monetary policy; just being less accommodative. They do not consider monetary tightening to occur until the Federal Funds rate is above the inflation rate. They maintain their actions to raise the Federal Funds rate from .25% to 1.25% have simply been to reduce the level of accommodation that they have been providing. They argue that monetary tightening is not occurring because inflation is still above 1.25%. This may all be technically accurate, but for the average person or business, raising interest rates makes conditions tighter if you need to borrow. It either makes it more expensive to borrow or disqualifies you from being able to borrow because of the higher interest expense. I suspect that the average American would say the difference between “reducing accommodation” and “tightening” is a matter of semantics.
Quantitative Tightening is another way to raise interest rates. From a simple supply and demand standpoint, if the government and corporations are still issuing the same level of debt then supply has not changed but demand has changed because someone who was buying this debt (i.e. the Federal Reserve) is no longer buying the same amount. All else being equal, unless someone else increases the amount that they buy, interest rates would have to rise to attract new buyers. We have already seen bond yields rise slightly in anticipation of the Federal Reserve continuing to raise the Federal Funds rate and beginning Quantitative Tightening.
The fact that the Federal Reserve has begun the process of Quantitative Tightening highlights the need for Congress to enact fiscal policy to stimulate the economy. The Federal Reserve is sending the message that it has completed its attempts to provide stimulus to the economy and now Congress needs to take over the job. After almost 10 years of constant focus on the Federal Reserve and its actions, the Federal Reserve is doing its best to deliver the message “move along, nothing to see here” and shift attention over to Congress. In reality we need to pay attention to both the Federal Reserve and Congress. Policy mistakes from either monetary policy or fiscal policy are what have traditionally caused a recession.
Steve Scranton is the Chief Investment Officer and Economist for Washington Trust Bank and is a CFA charter holder with over 30 years of investment experience with equities, tax-exempt and taxable fixed income securities. Steve actively participates on committees within the bank to help design strategies and policies related to client and bank owned investments. Steve also serves as the economist for the Bank and has been a featured speaker for both client and professional organization events throughout the Northwest.