Link: Federal Reserve

u/blurryk note: this is an abridged posting of the speech transcript, trimmed to about 1/2-1/3 of original size, see link for full text. Bolding is my editorialization to highlight what I view as key points within the summary.

• Thank you, it is great to be here. I'm pleased to participate in this panel to discuss a policy action now being implemented by central banks around the globe: quantitative tightening (QT). I want to thank Kristin, Matt, and Wenxin for putting together a great paper that provides an overview of the effects of QT across seven central banks.
• Often called "large-scale asset purchases" (LSAPs) by central bankers, the view of quantitative easing, or QE, as a tool to add monetary policy accommodation and QT to tighten policy has changed over time. When it was used during and after the Global Financial Crisis, QE was deemed an "unconventional" tool in central banks' arsenals. But QE has now been used numerous times in the past two decades for extended periods when the policy rate was at the effective lower bound, so I would say it is no longer unconventional.
• I will focus my comments on four points: (1) the evidence that the effects of QE are asymmetric to the effects of QT; (2) the execution of QE versus the execution of QT in the United States; (3) the role of announcement effects of QT; and, finally, (4) who has taken the Fed's place in buying assets when we withdraw from the market. I will then end with some thoughts about issues facing the Federal Reserve as we move forward with normalizing our balance sheet.

The Asymmetry of Quantitative Easing versus Quantitative Tightening

• For me, one of the most interesting results of the paper is that the announcement effects of quantitative easing are much larger than the announcement effects of quantitative tightening. The authors find that announcements of QT have a small but statistically significant effect in increasing government bond yields—about 4 to 8 basis points. But this effect is much smaller, in absolute terms, than the prevailing estimates of the decrease in yields from announcements of QE. The conclusion is that the interest rate effects of QE and QT are asymmetric.
• Ever since central banks initiated QE in response to the Global Financial Crisis, academics have debated its effectiveness[...] **²**By lowering interest rates on longer-maturity assets, which pay a higher interest rate than reserves, the central bank can stimulate the economy in a manner similar to lowering the policy rate. But by this logic, when QT reverses QE, asset prices should fall and yields should rise in equal magnitude. Thus, any positive effects derived from QE would be reversed when QT occurs. This suggests that QE and QT may cancel each other out in welfare terms.
• To me, for QE to be beneficial on net, there has to be asymmetry in the effects of QE relative to QT. My thinking on this has long been guided by the conclusions of a paper I wrote with Alex Berentsen about optimal stabilization policy, which is what QE and QT ultimately should be about.³ The gist of the argument is that when shocks and frictions to trading arise suddenly, the central bank can take actions such as injecting reserves to ease trading frictions or credit constraints and improve welfare. But by waiting until the frictions and shocks dissipate before undoing the injections, the positive effects are not reversed.

2 There are several theories for how QE works. The market segmentation theory suggests that assets of different maturities are imperfect substitutes, so a lower supply of long-term assets and a higher supply of short-term assets would imply that long-term interest rates fall and short-term interest rates rise. The preferred habitat theory suggests that financial market participants prefer certain asset maturities over others and the price (or interest rate needs to adjust to change their desired mix of holdings.)

3 For details of the model and results, see Aleksander Berentsen and Christopher Waller (2011, "Price-Level Targeting and Stabilization Policy,") Journal of Money, Credit and Banking, vol. 43, Supplement 2 (October, pp. 559–80.)

The Execution of Quantitative Easing versus Quantitative Tightening

• Turning to the impact of QE and QT on interest rates, analysis often focuses on the term premium. There are three key elements of asset purchases that change the term premium: (1) the expected path of QE, which includes the amount and timing of purchases; (2) the length of time the central bank is expected to hold the additional securities; and (3) the expected path of QT, including the amount and timing of redemptions, which importantly depends on the desired ultimate size of securities holdings (and reserve balances) of the central bank. As soon as an asset purchase program is announced, these expectations are formed, resulting in the term premium effect, or TPE, on interest rates.
• First, there are two ways that QE can be implemented, and they have different impacts on interest rates. These are what I call closed**- or** open-ended QE programs. Closed-ended QE programs involve an announcement of a fixed stock of purchases over a fixed period of time. An example of this type of asset purchase program was initiated by the Fed in March 2009.⁴ Open-ended QE simply gives a purchase amount per month but no calendar endpoint, so the expected size of the program is unspecified[...] if one wants a particular impact on interest rates at the announcement date, one might lean toward a closed-ended program[...] One might prefer an open-ended program over time because it dynamically responds to the evolution of economic conditions. The program could be halted or extended as conditions improve or worsen, unlike a closed-ended program.
• The second factor affecting the path of asset purchases is that it is very important that QE be credibly followed by QT. If QE is viewed as nothing more than a permanent injection of money into the economy, it would likely create inflation[...] Pre-committing to QT is what allows the injection of reserves into the economy without inflation or other longer-run distortions of market is important that the central bank commit to normalizing its balance sheet.
• The third factor is that it is important for a central bank to move carefully as it comes to the end of QT and the desired level of ample reserves. The endpoint should be related to the expectation of the banking system's demand for reserves. In the United States, we saw stresses in money markets in the fall of 2019, when the Fed reduced the level of reserves during balance sheet normalization through July and then there was heavy issuance of Treasury securities in September. The level of reserves likely went a bit too low.⁶ [...] For this reason, even if QE is an open-ended program, QT is more likely to resemble a closed-ended program.

4 An example of a closed-ended program is from March 2009, when the Federal Open Market Committee (FOMC noted that "to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months"; see paragraph 3 of the March 2009 FOMC statement, which is available on the Board's website at) link. An example of an open-ended program is from December 2020, when the FOMC stated it would keep buying $120 billion per month in securities "until substantial further progress has been made toward the Committee's maximum employment and price stability goals"; see paragraph 4 of the December 2020 FOMC statement, which is available on the Board's website at link.

6 For a discussion of the September 2019 experience, see Sriya Anbil, Alyssa Anderson, and Zeynep Senyuz (2020, ")What Happened in Money Markets in September 2019?" FEDS Notes (Washington: Board of Governors of the Federal Reserve System, February 27.)

Quantitative Tightening in the United States

• Let me now turn more directly to the authors' paper and two of their findings. First, as I mentioned earlier, they find central banks' QT announcements have only a small effect on interest rates. To conduct this analysis, the authors do an event study around QT announcements, which requires them to identify "surprises" in the QT announcements. As the authors acknowledge, this is not a trivial exercise. My comment here is to point out why identifying a QT announcement surprise is challenging when considering examples in the United States.
• Let me walk through the evolution of the Fed's QT communications in the spring of 2022 to consider how various communications affected the expected path of QT.⁷ Recall that QE ended in March 2022.⁸ Heading into April, it was likely that markets expected a redemption path somewhat like the Fed's 2017–2019 QT plan.⁹ That plan phased in redemptions over 12 months and ultimately allowed, at most, $30 billion of Treasury securities and $20 billion of agency mortgage-backed securities (MBS) to be redeemed each month. On April 5, 2022, then-Vice Chair Lael Brainard gave a speech that noted the balance sheet would shrink considerably more rapidly than in the previous case of QT; specifically, she said that "significantly larger caps and a much shorter period to phase in the maximum caps compared with 2017–2019."¹⁰ The next day, the Federal Open Market Committee (FOMC) minutes provided additional information on the expected maximum monthly caps and phase-in period, saying participants generally agreed to a three-month phase-in and caps of $60 billion and $35 billion for Treasury securities and agency MBS, respectively[...] The 10-year Treasury yield rose 19 basis points over the two days of the Vice Chair's speech and the FOMC minutes—that is, 12 basis points on the day of her speech and another 7 basis points on the day of the FOMC minutes—and a total of 37 basis points over that week[...] there was little change in the 10-year Treasury yield that day and week (negative 4 basis points on the day of the announcement and 2 basis points over the five-day period). So, when doing event studies, it may be difficult to estimate the full impact of QT announcements by simply looking at the formal announcement of the QT plan.
• Let me turn to a second point of the paper, about which types of investors have increased their securities holdings as the Fed has reduced its holdings. When a central bank steps away from asset purchases and begins to shrink its balance sheet, a common question is, who will step in and take the central bank's place in buying securities? I always respond by saying, "Why is this important?" If the government bond market is broad and deep, there will be plenty of buyers—there is no need to worry about who will buy the government debt[...] The authors focus on the reduction in aggregate securities holdings of central banks and find that households and broker-dealers are the main investors absorbing the redeemed securities.
• For Treasury securities, I also find that since the 2022 start of QT, households have boosted their market share the most, and broker-dealers have also increased their share. For agency MBS, not only has the market shares of those two investor types increased, but so has the market shares of money market funds.
• As currently categorized, the Financial Accounts household category includes hedge funds. The Federal Reserve Board is working to segregate hedge funds in this data set. In the interim, the Board publishes separate data on the balance sheets of domestic hedge funds.¹² [...] I find that it is not the hedge funds that are responsible for the increase in household market share. This means the increase is driven by the other household investors: actual households and nonprofit organizations.
• The buyers are not a narrow set of deep-pocketed, sophisticated investors but rather the American public. As a result, the pace of runoff is not a problem. As we have seen with the current phase of QT, runoff up to $95 billion a month is not causing substantial strains in financial markets—something that a few years ago would have surprised a lot of people, given the worries about QT that were common prior to 2022.

7 Prior to the spring announcements, the Federal Open Market Committee (FOMC began discussions on policy normalization as reported in the December 2021 FOMC minutes. It was noted that some participants observed that the balance sheet could potentially shrink faster than the previous experience. The 10-year Treasury yield moved up several basis points around the release of the minutes.)

8 In March 2022, the Federal Open Market Committee (FOMC indicated that it "expects to begin reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities at a coming meeting"; see paragraph 3 of the March 2022 FOMC statement, which is available on the Board's website at) link. This language signaled the Fed would be holding the peak amount of securities on its balance sheet for just a short period of time, which turned out to be between March and the end of May.

9 In January 2022, the Federal Open Market Committee provided a statement on "Principles for Reducing the Size of the Federal Reserve's Balance Sheet," but it did not provide information about the timing or pace of redemptions; the statement is available on the Board's website at link.

10 See Lael Brainard (2022, ")Variation in the Inflation Experiences of Households," speech delivered at the Spring 2022 Institute Research Conference, Opportunity and Inclusive Growth Institute, Federal Reserve Bank of Minneapolis, Minneapolis, April 5.

12 Data on the balance sheet of hedge funds is available on the Board's website at link.

Normalization

• As the Federal Reserve continues its QT program, I support further thinking about how many more securities to redeem. We have an overnight reverse repurchase agreement facility with take-up of more than $500 billion, and I view these funds as excess liquidity that financial market participants do not want, so this tells me that we can continue to reduce our holdings for some time.
• Chair Powell has noted that the FOMC will begin to discuss slowing our redemptions at our FOMC meeting this month, which will help us transition into whatever definition of "ample" we deem appropriate. Changing our pace of redemptions will occur when the Committee makes a decision to do so, and the timing will be independent of any changes to the policy rate target. Balance sheet plans are about getting liquidity levels right and approaching "ample" at the correct speed.
• Thinking about longer-term issues related to the Fed's portfolio, I want to mention two things. First, I would like to see the Fed's agency MBS holdings go to zero. Agency MBS holdings have been slow to run off the portfolio, at a recent monthly average of about $15 billion, because the underlying mortgages have very low interest rates and prepayments are quite small. I believe it is important to see a continued reduction in these holdings.
• Second, I would like to see a shift in Treasury holdings toward a larger share of shorter-dated Treasury securities. Prior to the Global Financial Crisis, we held approximately one-third of our portfolio in Treasury bills.¹³ Today, bills are less than 5 percent of our Treasury holdings and less than 3 percent of our total securities holdings. Moving toward more Treasury bills would shift the maturity structure more toward our policy rate—the overnight federal funds rate—and allow our income and expenses to rise and fall together as the FOMC increases and cuts the target range. This approach could also assist a future asset purchase program because we could let the short-term securities roll off the portfolio and not increase the balance sheet.¹⁴ This is an issue the FOMC will need to decide in the next couple of years.
• In conclusion, let me be clear that this is a great paper that will serve as a major reference for researchers and central banks. The authors' analysis will surely have a much longer shelf life than my discussion of it.

13 A Treasury bill is a security backed by the U.S. Treasury Department with a maturity of up to 52 weeks. A bill is sold at a discount, and at maturity the investor receives the par value of the security.

14 There may be other considerations for holding a sizable share of bills in the Fed's portfolio. For example, Vissing-Jorgensen (2023 argues for considering the convenience yield impact of bills; see Annette Vissing-Jorgensen (2023), "Balance Sheet Policy above the ELB," paper presented at the ECB Forum on Central Banking, held in Sintra, Portugal, June 26–28.)