Quantitative Tightening (QT) Explained

The Federal Reserve started raising interest rates in March 2022 to stymie soaring inflation. But the nation’s central bank has been doing something else to control price growth: quantitative tightening (QT).
Experienced investors may experience a double take at that esoteric phrase. After all, the Fed spent the better part of the last 14 years engaged in quantitative easing (QE).
QE occurs when a central bank, such as the Federal Reserve, attempts to reduce long–term interest rates to bolster business activity through lower lending rates and increase the money supply.
During the Great Recession, the problem was that the economy was too cold. Today, it’s the reverse.
“Quantitative tightening is the opposite of quantitative easing,” says Wells Fargo corporate and investment bank chief economist Jay Bryson. “In a nutshell, it helps to bring up long-term interest rates.”
What Is Quantitative Tightening?
While you can be forgiven for not closely monitoring the day-to-day gyrations of the Treasury market, you’ve surely noticed surging mortgage rates and a topsy-turvy stock market. For that you can, in part, thank the Fed’s quantitative tightening policy.
The Fed’s mission is to keep prices stable and maximize employment. With inflation sitting near 40-year highs, the Fed is focused primarily on returning price growth to its 2% target. That’s why the Fed has raised the federal funds rate so aggressively: That’s the most direct way it can control interest rates.
Additionally, the Fed will lower its balance sheet in the hopes that doing so will raise yields on longer-term bonds. This is what is meant by quantitative tightening.
How Does Quantitative Tightening Work?
In late 2021, Fed officials prepared the market that the era of loose money was ending. Fed Chair Jerome Powell admitted that inflation wasn’t transitory, despite what he and other officials had been saying for months.
The Fed would need to raise interest rates quickly and wind down its monthly purchases of billions of dollars worth of bonds. But that wasn’t all.
In January 2022, the Fed clarified that rather than adding to its balance sheet, as it had been doing since the onset of the Covid-19 pandemic, it would allow the bonds (mortgage-backed securities and Treasurys) to mature.
This move, along with a period of rate hiking, would hopefully signal to investors that the Fed was serious about curbing inflation by raising the costs of borrowing money. In theory, it would weaken economic activity.
“Quantitative easing is a way to stoke animal spirits,” says Tim Holland, chief investment officer at Orion Advisor Solutions. “It’s the exact opposite with quantitative tightening. They’re depressing animal spirits by pulling money out of the economy.”
The move makes a certain amount of intuitive sense. After all, the Fed only directly controls short-term rates.
But by selling bonds, they’re pushing down the prices of longer-term securities, which raises the yield. (Bond prices and yields are inversely related.) Higher borrowing rates will make it less advantageous to take out loans, which the Fed hopes will lower demand and push down inflation.
How Long Will Quantitative Tightening Last?
Given the scale of inflation and how long prices have run in front of the Fed’s 2% target, it’s remarkable the Fed was buying bonds up until March 2022.
This marked the end of a long spending spree that saw the Fed’s balance sheet jump from about $4.2 trillion in February 2020 to almost $9 trillion by mid-March.
To put that in perspective: The Fed raised its holdings from less than $1 trillion before the Great Recession to almost $4.5 trillion by 2016. The Fed lowered its balance sheet for a period between 2017 through 2019.
The current plan is to reduce the balance sheet by roughly $90 billion per month, compared to the monthly $120 billion in securities purchases that began in June 2020. (This was after adding an astounding $3 trillion in the previous three months.)
For how long will they tighten? No one knows.
Researchers at Bank of America expect the Fed’s balance sheet to wind up at 34% of U.S. gross domestic product (GDP) by the end of the year, down from 37% the prior year.
Should the Fed successfully fight inflation without incurring a recession, then Bryson expects the Fed’s balance sheet to drop by almost $2.5 trillion through early 2025.
How Does Quantitative Tightening Affect You?
Of course, the Fed’s best-laid plans may not come to fruition. Bryson expects a full-fledged recession to commence sometime in 2023, which would cause the Fed to cut rates by 1 percentage point by the end of the year.
The Fed, in this scenario, would feel safe in an easing policy because inflation would have come closer to its 2% target.
A policy of lower interest rates would force the Fed to pause its quantitative tightening.
Bryson expects somewhere in the $8 trillion range. Whether or not the Fed would subsequently resume QT in 2024, or learn to live with a higher balance sheet than normal, would be a question for another day.
In the meantime, it’s important to remember that the Fed is in uncharted waters. “They’ve never done it at this level,” Holland says.
That means you should expect the volatility characterized by 2022 to continue. After missing the mark last year, the Fed is determined to get inflation down to its target level over the next few years.
Companies can’t rely on cheap money for growth. Investors and savers should be prepared for rocky days ahead and that hiring could slow as corporations retrench. Those in the market for a house should build up their credit scores and down payments.
The easy days of meme stocks going to the moon are long gone, and the hard slog may have only begun.