When will quantitative tightening end?

Summary

At its meeting on March 18-19, the FOMC announced that it would be slowing the pace of its balance sheet runoff effective April 1. The monthly cap on Treasury security runoff was reduced from $25 billion to $5 billion, while the monthly cap on mortgage-backed security (MBS) runoff was left unchanged at $35 billion.

The decision to slow quantitative tightening (QT) reflects the Committee's efforts to balance two competing demands. On the one hand, money market conditions generally remain well-behaved, and bank reserves are unchanged over the past year. Taken in isolation, these factors argue for full steam ahead on QT.

However, the Federal Reserve already has shrunk its security holdings by more than $2 trillion since QT began in June 2022, and conditions in funding markets can change rapidly, as evidenced by the September 2019 repo market disruption. Furthermore, debt ceiling dynamics are leading to an artificial and temporary boost to bank reserves at present. These factors argue for a more cautious approach to additional balance sheet runoff.

Continued QT and an eventual resolution to the debt ceiling should push bank reserves below the key $3 trillion threshold by year-end. Accordingly, we look for QT to run at its current pace through the end of the year and then cease. Starting in 2026, we expect the Federal Reserve to keep its balance sheet flat through roughly the middle of the year. At that point, we project bank reserves would be roughly $2.8 trillion, and we would expect balance sheet growth to resume to keep the reserves-to-GDP ratio steady around 9%.

Under this scenario, cumulative balance sheet runoff would be just shy of $2.5 trillion—a reduction in the central bank's security holdings that exerts 20-40 bps of upward pressure on long-term interest rates.

Note that even if aggregate balance sheet runoff ceases, that does not mean that balance sheet policy has shifted to neutral. If the Fed's balance sheet is held flat for an extended period of time, then it will still be shrinking as a share of GDP.

Furthermore, the composition of the balance sheet can continue to evolve such that policy accommodation is still being removed. We look for MBS runoff to continue indefinitely as the Federal Reserve strives to reduce its mortgage holdings and slowly return to holding primarily Treasury securities. In order to keep the total balance sheet unchanged amid ongoing MBS runoff, we look for the Federal Reserve to start buying Treasury securities such that they replace MBS paydowns one-for-one. Returning to a primarily Treasury security portfolio would reduce the support that the central bank lends to the mortgage market.

Another factor to consider is the weighted-average maturity of the central bank's Treasury security holdings. Slowly replacing MBS with shorter-dated Treasury securities, such as Treasury bills, would re-weight the Fed's balance sheet away from longer-dated securities and toward shorter-dated securities, putting some very modest upward pressure on longer-term yields, all else equal.

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