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The Fed is likely to launch quantitative tightening around mid-year, setting progressively higher caps for the value of maturing debt allowed to run off each month and maxing out at a monthly pace above the peak QT rate of USD50 billion in 2018, former Fed officials told MNI.
The more aggressive approach to shrinking its balance sheet is part of the Fed's overall effort to pick up the pace of policy tightening as the risk recedes that the economic recovery will reverse or money markets undergo the same turmoil as in September 2019 when bank reserves became scarce, the ex-officials said.
"It looks like they will move faster in time and somewhat faster in terms of the level of short-term rates when they start, and the amounts of run-off will likely be higher," former New York Fed president Bill Dudley said. "The program will be similar to last time, with caps that increase over time."
It took the Fed a year to ramp up to a peak QT rate of USD50 billion from USD10 billion a month in the tightening cycle that began in 2015, and QT was only launched after the fed funds rate target rose above 1%.
This time, run-offs could start after two or three rate hikes and see a "fairly rapid ramp-up" every month, said Derek Tang, an adviser with former Fed Governor Larry Meyer's Monetary Policy Analytics group.
"The caps on reinvestments will be higher because they bought at a much higher pace this time and they seem more confident the market can take it, and they want to get the balance sheet down quickly."
Tang expects the caps to reach USD100 billion a month, potentially evenly split between Treasuries and agency MBS at first, then shifting further out of MBS and into Treasuries to align with the Fed's long-term goal of only holding Treasuries.
MOVING AWAY FROM MBS
Shifting the portfolio mix by reinvesting maturing MBS returns into Treasuries "is something they could easily find quite attractive -- low-hanging fruit as it were," former Richmond Fed President Jeff Lacker told MNI. "I suspect there would be enough support around the table, given how hot the housing market is and the general sense that there is too much rather than too little stimulus in place."
But an MBS-led QT program might be too little too late to cool the property market, said Danielle DiMartino Booth, former Dallas Fed adviser and CEO of Quill Intelligence, adding that private equity funds and other investors were continuing to pour into the sector despite now-rising mortgage rates.
“It’s just a swarm of investors. They’ve got more dry powder than they’ve ever had, the Fed just can’t rein them in. At this point they’ve lost the battle in terms of quickening MBS tapering vis a vis Treasuries."
If the Fed wants to speed up the timeline for moving into an all-Treasuries portfolio, "they can move MBS reinvestment into Treasuries right away," said Joseph Wang, who left the New York Fed's markets desk last year. But knowing the small effect of MBS purchases on housing prices, the Fed is more likely to phase its MBS reinvestments into Treasuries over time, he said.
Wang isn't convinced that the Fed will let the balance sheet shrink at a much faster rate than it did in 2018, even with some USD2.5 trillion more reserves in the system than in 2018 and the newly-created standing repo facility as a backstop should reserves come close to scarcity.
"One of the hardest things about QT is you don’t know at what point it will break. There's a huge effort within the Fed system to figure out where that point is, and what they think they learned is it’s higher than they thought it was, so that makes them cautious."
Having the standing repo facility "gives them more comfort to do QT faster and deeper," but as a conservative institution, the Fed is loath to rock markets.
"QT is boring. I think that’s still the perception. It's not the big thing that affects the economy, so the much more important debate is the pace of hikes."
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