Quantitative tightening… The Fed is once again passively shrinking its balance sheet through the redemption of maturing Treasury securities and MBS. Balance sheet reduction is also known as quantitative tightening. The Fed could potentially undertake the active sale of MBS and/or Treasury securities, but doing so in the foreseeable future will depend on several parameters.
The normal size of the Fed's balance sheet… The precise impact of QT on Treasury yields and broader financial conditions will ultimately depend on how much the Fed cuts its $9 trillion balance sheet. So what is the "normal" or "equilibrium" size for the Fed's balance sheet, and how long does it take to reach that size? Between 1990 and 2007, the Fed's balance sheet averaged about 6% of nominal GDP. Returning to this ratio today would require a balance sheet of roughly $1.5 trillion, with a massive $7.4 trillion drop from current levels.
Of course, the Fed's balance sheet is unlikely to return to $1.5 trillion anytime soon. Plus, a sizeable balance sheet asset framework makes it much easier to return to QE when needed should another deep economic downturn occur at some point in the future.
Federal Reserve balance sheet size historical development… Gray areas are marked as recession periods. Source: Federal Reserve
When will QT end and how big will the balance sheet be at this point? The Fed's experience with QT between 2017 and 2019 provides a useful template for when the central bank might stop QT in the current period. The Fed's downsizing is likely to end when the amount of bank reserves drops to around 8.5% of GDP. The ratio of reserves to GDP is expected to approach 8.5% by the beginning of 2025. Therefore, QT needs to continue unabated into 4Q24 for the balance sheet to reach 'equilibrium'. This indicates that QT will slow down in 1Q25.
Under this scenario, the Fed's balance sheet will shrink from its current size of US$8.9 trillion to approximately US$6.5 trillion in 1Q25. The probability of a recession is pretty high right now. If the economy goes into a downturn in the foreseeable future, the Fed will likely end QT long before the balance sheet reaches $6.5 trillion. In either scenario, the Fed's balance sheet will remain high for the foreseeable future.
Total reserves of deposit banks… Source: Federal Reserve, St. Louis Fed Fred
Conclusion? The Fed will continue to raise interest rates. The increase in the size of the tightening may be in the form of active MBS sales or raising the terminal interest rate. The effect that will be a criterion for faster or slower tightening of monetary conditions will come from inflation and forward-looking expectations. The Fed may adopt a strategy of actively using not only interest rates but also the balance sheet as long as the effects of high inflation persist. Since demand inflation is an area that can be directly intervened, a situation consisting of inflation originating from the supply chain or raw material supply will show that the tightening of the Fed works.
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