Here be dragons: The Federal Reserve is charting new territory. Where will the Fed’s effort to shrink its balance sheet take us?

It’s rumored that medieval mapmakers marked unexplored and potentially dangerous regions of the world with the words, “Hic sunt dracones,” which means “Here be dragons.” Today, that caution can describe territory the Federal Reserve (Fed) is about to explore - a zone known as quantitative tightening.

Throughout the pandemic, Congress and the Fed provided unprecedented levels of fiscal and monetary stimulus that helped the US economy recover much more quickly than anticipated. As the country regained its health, people and businesses were flush with cash, and demand for goods increased faster than the supply of goods. That pushed prices higher. By June 2022, the Consumer Price Index marked inflation at 9.1%,[1] significantly above the Fed’s target inflation rate of 2%.

The Fed’s battle with inflation began late last year

The Fed began aggressively fighting inflation late in 2021. Since then, it has taken steps to normalize monetary policy by:

·?Ending quantitative easing. The Fed is no longer buying Treasuries and agency securities on the open market.

· Raising the federal funds target range. At the end of July, The Federal Reserve raised interest rates by 0.75%, repeating the action taken at their June meeting.?The current target range is now 2.25% to 2.50%.??The CME FedWatch Tool suggests the target range could be 3.50% - 3.75% by the end of the year.[2]

· Beginning to shrink its balance sheet. In May, the Federal Open Market Committee (FOMC) agreed to start quantitative tightening by letting $30 billion in Treasuries and $17.5 billion in agency mortgage-backed securities per month “roll off” its balance sheet, meaning it won’t reinvest the assets.

The Fed’s ventures into quantitative tightening territory

Quantitative tightening is relatively new territory for central banks. The Fed first engaged in quantitative easing — expanding its balance sheet to support the economy — following the financial crisis of 2007-08. Over the following decade, its balance sheet grew from less than $1 trillion to more than $4 trillion. After the economy stabilized, the Fed began its first foray into quantitative tightening, attempting to restore the balance sheet to pre-crisis levels.

From October 2017 to July 2019, the Fed let about $675 billion of its bond portfolio mature without reinvesting in the market. This reduced its balance sheet to about $3.7 trillion. However, market turmoil and liquidity concerns caused the Fed to pause its efforts in 2019. Afterward, the COVID-19 pandemic created a new set of concerns, and the Fed never restarted quantitative tightening. However, the Fed did engage in a new round of quantitative easing.

By June 2022, the Fed held $5.8 trillion in Treasuries and $2.7 trillion in mortgage-backed securities.[3] With its balance sheet as large as it has ever been, the Fed launched a second expedition into quantitative tightening in June. By September, the Fed expects to be on pace to reduce its balance sheet by about $95 billion every month.

How will quantitative tightening impact investors?

The Fed is in relatively uncharted territory. It’s possible the balance sheet reduction will be as orderly and uneventful as watching paint dry, as former Fed Chair Janet Yellen once suggested. It’s also possible we’ll see volatility as the bond market adjusts to a new environment. No one can be sure how the Fed’s second venture into quantitative tightening will turn out, but it’s likely to provide new chapters for economics textbooks.

If you have questions about how quantitative tightening may impact financial markets , contact me at [email protected] or 617-531.6954.

[1] Bureau of Labor Statistics. ‘Consumer Price Index Summary.’ July 13, 2022. Cited July 18, 2022.

[2] CME Group. CME FedWatch Tool: Countdown to FOMC. Cited July 10, 2022.

[3] United States Federal Reserve. H.4.1: Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks. Cited July 10, 2022.