Fed Policy is Tighter Than it Looks, and is Set to Tighten Further

In our recent op-ed for Barron’s, we argued that the Fed and the market were materially underestimating the impact of the Fed’s balance-sheet reductions, or Quantitative Tightening (QT), on financial conditions. We demonstrated how the tightening effects of QT can be translated into QT-equivalent policy rates, or the rates needed without QT to have the same impact produced by the actual policy rate with QT. The maximum impact QT will have on monetary policy is determined by the date at which balance-sheet reductions will end and the total amount of assets to be shed from the balance sheet.

During the QT cycle of 2019, the Fed halted QT when bank reserves became scarce, owing to banks drawing on reserves to buy bonds. During the current cycle, however, measuring the effect of QT is complicated by the phenomenon of money-market fund cash sitting in the Fed’s Overnight Reverse Repurchase Agreement Facility (ON RRP). Rather than reserves declining during the current QT cycle, they have been protected by ON RRP balances falling alongside Fed assets. Dallas Fed president Lorie Logan has therefore argued that the Fed should “slow the pace of runoff as ON RRP balances approach a low level.”

Market and Fed-research estimates of the end of QT range from the second quarter of 2024 to the second quarter of 2025. We expect ON RRP reserves to be drained this summer—at the shorter end of this range. Assuming the Fed maintains its current pace of balance-sheet reductions ($95 billion per month), we therefore estimate that the QT-equivalent policy rate hike will range from a low of 59 basis points to a high of 100 basis points, as shown in the above graphic. Considering projections of the actual policy rate going forward, this translates into a QT-equivalent policy rate that could peak anywhere from 6.0% to 6.2%. These rates are, of course, much higher than the current policy rate of 5.375%, and even higher than a recent “Taylor Rule”-generated desired rate of 4.50%, as calculated by Apollo Chief Economist Torsten Slok.

In short, then, we continue to believe that the Fed and the market are significantly underestimating the tightness of monetary policy today, and particularly that going forward into 2025.

Notes:

1 Bank of America and Barclays predict that the Fed will begin to unwind QT in April and end QT altogether in mid-summer.

2 The Overnight Reverse Repurchase (ON RRP) facility is estimated to be drained by June 2024 by the authors’ calculations.

3 Deutsche Bank analysts predict that QT could end as early as June 2024. RBC Capital Markets predicts that the Fed will wind down QT in mid-2024.

4 JP Morgan economists predict that the Fed will stop QT by end of summer 2024.

5 The New York Fed’s Survey of Primary Dealers indicates that banks believe QT will end in the last quarter of 2024.

6 Goldman Sachs and Morgan Stanley analysts estimate that QT will end by the first quarter of 2025.

7 We calculated this estimate with Fed staff methodology, which uses the ratio of total assets to nominal GDP to determine the end of QT.