The Fed is raising interest rates, but there is another tool it hopes will help crush inflation and deflate market bubbles

• The Fed has raised interest rates this year, but that’s only half of its approach to tackling inflation and tackling foamy markets.
• Quantitative tightening aims to suck excess liquidity from the market, fight inflation and deflate bubbles.
• Experts say it may go too far, but the Fed can avoid a crisis if it gradually eases the QT.

Inflation has weighed on markets all year, with the Fed raising rates by more than 300 basis points in a race to rein in sky-high prices.

Aggressive, historic rate hikes are only half of its approach, however, and there is another tool the central bank has used more recently to help crush inflation and deflate the market bubbles that have formed in the following years of accommodative monetary policy.

Unfortunately for investors, this tool should also weigh on the stock and bond markets, perhaps even more than the Fed’s rate hikes. Such a massive change in liquidity conditions has raised fears that quantitative tightening – the runoff from the Fed’s $9 trillion balance sheet – could end in a stock market crash.

Here’s how two experts explain the Fed’s QT regime and why it’s a delicate balance between fighting inflation and keeping markets afloat.

What is quantitative tightening and what does reducing liquidity mean?

When the Fed undertakes quantitative tightening, it reduces the size of its balance sheet. It is the assets that the central bank has accumulated, such as long-term government bonds, that eventually mature and allow the Fed to recover the principal of those bonds. Once they mature, the Fed can either reinvest that money or reduce the size of its balance sheet by simply letting the bonds “run off”. During quantitative tightening, the Fed chooses not to reinvest.

This is slightly different than if the Fed were actually selling the bonds from its balance sheet into the market, but it has a similar effect of pushing rates up.

The Fed removes about $95 billion of Treasuries and mortgage-backed securities from its balance sheet per month. Essentially, this reduces the demand for long-term bonds, which causes real long-term interest rates to rise.

What is the effect of QT?

The Fed hopes this can help reduce inflation. When real long-term interest rates rise, it drives down asset prices, causing inflation to slow. Higher rates also encourage households to save more, discouraging the kind of consumption or investment that overheats the economy and drives inflation.

Does it impact stocks?

Like higher interest rates, which can erode corporate profitability and depress stock prices, QT can have a negative effect on stocks.

Remember that QT drains liquidity from the markets by removing a guaranteed buyer of massive amounts of debt securities. Withdrawing so much liquidity from the market inevitably has a cascading effect, and bubbles like the meme-stock craze that gripped markets during the pandemic will fade.

According to Amir Kermani, an economist at UC Berkley, it’s also because when long-term bond interest rates rise, investors will want to switch from equities to long-term bonds.

So, is the madness of meme stocks over?

Taken together, quantitative tightening and interest rate hikes will likely put a damper on meme stocks and asset speculation in general, RBA analyst Michael Contopoulos told Insider.

But it’s not just quantitative tightening.

“It would be way too simplistic to boil it down to that,” Contopoulos said. He pointed out that much of the pandemic-era stimulus money had withdrawn from savings, which was a major driver of interest in stocks. Fed rate hikes have also reduced appetite for equities this year by raising short-term interest rates.

With government-backed three-month Treasury bills yielding over 4%, why risk money in the stock market which is down 20% year-to-date?

When will QT end?

The quantitative tightening regime can’t last forever, Kermani says, and it’s likely the Fed will have to start slowing the pace of balance sheet reduction. This is largely because the money that leaves the balance sheet comes mainly from excess reserves, which are used by banks to meet liquidity needs.

Kermani believes the financial system may not be able to tolerate banks’ excess reserves falling below $2 trillion, which could lead to the Fed shutting down QT at the end of 2023. He added, however, that the Fed would likely wait for clearer signs of inflation before slowing the pace of quantitative tightening.

Are stocks rallying after the end of the QT?

There is hope for a bull run in 2023, according to Bank of America, which says even a shift from quantitative tightening to “DIY” would boost stocks.

However, other experts have doubts about the tailwinds provided by the end of QT.

“The quantitative tinkering will have a temporary effect,” Contopoulos said. “Our research shows that the earnings recession is about to begin and will accelerate through 2023.”

He noted that equities were largely influenced by the Fed “bursting the liquidity bubble” in the first six to nine months of this year, but that Fed policy will have less of an impact on equities more later, as markets focus on corporate earnings.

“I think the next leg of the race to the bottom in stock prices will be driven more by the lack of earnings growth than anything the Fed is doing.”

Could the Fed be messing this up?

Kermani says quantitative tightening won’t necessarily lead to a crash in stock prices, as long as the Fed gradually shrinks its portfolio. But he thinks it would be a mistake to suddenly stop the quantitative tightening process at this stage.

“It is a huge mistake for the Federal Reserve to change its mind because it is afraid of what will happen to stock prices. We do not want to live in a world where the Fed is responsible for ensuring the market So I think a gradual adjustment in market prices is actually not bad,” he said.