MNI INTERVIEW: Fed QT Likely To Linger After Rate Cuts Start

The Federal Reserve could keep shrinking its balance sheet even after it begins interest rate cuts that investors expect to start later in the year, Victor Valcarcel, a former Kansas City visiting scholar with new research on QT2 told MNI.

“If inflation were to normalize further, if the Fed were to slow it down and to achieve a more desirable level of inflation – It's not a foregone conclusion that the Fed at that point will end QT,” said Valcarcel, an associate professor of economics at the University of Texas at Dallas, in an interview.

Despite his research findings that QT2, which began in June 2022, had a much greater effect on bond yields and rate spreads than the first round of balance sheet runoffs back in 2018-2019, Valcarcel praised the Fed for successfully divorcing balance sheet policy from moves in the federal funds rate.

“I am fully behind the Fed’s continued almost defensive statement that the federal funds rate is the primary tool of monetary policy,” he said.

The Fed’s considerations for how far to shrink the balance sheet are related to what it feels might be an appropriate level of reserves in the financial system rather than any view of how the size of its asset base might affect the outlook for inflation and employment, according to Valcarcel.

“We’re living in an ample reserves system but apparently they want to have a certain buffer in reserves, so whatever happens we’re not going to back to a scarce reserves system,” he said.

“Barring unforeseen shocks we could see inflation moderate, and yet that doesn’t necessarily mean in my opinion suggest the Fed would completely end paying attention to its balance sheet." (See MNI INTERVIEW: June CPI Seals Deal On Sept Fed Cut-Tilley)

PLAYING WITH THE SPREAD

Valcarcel said that one untapped monetary tool the central bank could use in future tightening cycles is to widen the spread between the federal funds rate and its administered rate, the so-called interest on reserve balances.

“The next time they need to tighten in addition to unwind they could actually play with the fed funds-IOER spreads. That might generate a faster credit contraction,” he said.

The central bank effectively took that possibility off the table for QT2 because of the creation of a Standing Repo Facility that fixed the cost for banks of holding additional reserves.

QT2 A ‘DIFFERENT ANIMAL’

Varcalcel’s research, a follow up of a 2023 paper he co-authored with a KC Fed economist, showed the announcement effects of QT2 were much greater than QT1, making it a “different animal” entirely.

“We find virtually all the balance sheet announcements in the QT2 period exert a material and significant influence on yield spreads,” the paper says, in part because the first round of QT took place in a period of relative market calm while QT2 was happening in conjunction with a surge in interest rates as a response to the post-covid inflation shock.

“The effects of QT1 on financial conditions manifested largely upon implementation, rather than announcement. On the other hand, QT2 announcements had large signaling effects. Our findings suggest the dominant mechanism of QT1 was one characterized by important liquidity effects, whereas the more likely dominant mechanism of QT2 was one of market expectations.”