US economy

QT is not nearly done

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Good morning. It was a quiet day in both stock and bond markets yesterday. Too quiet, as they say. Perhaps traders were holding their breath before today’s inflation report, which many expect to come in a bit hot for methodological reasons. Ready to exhale? Email us: and

How far quantitative tightening can go

If the market is to be believed, the Fed’s rate increases are done, or very nearly so. Is the other tool of US monetary tightening, quantitative tightening, also near the end of its run? 

The Fed has said in the past that interest rate and balance sheet policy should work in unison, sending a single, clear message. But no longer. Here is Fed chair Jay Powell in July:

Imagine it’s a world where things are OK, and it’s time to bring rates down from what are restrictive levels to more normal levels. Normalisation, in the case of the balance sheet, would be to reduce QT or to continue it, depending on where you are in the cycle. So they are two independent things. Really, the active tool of monetary policy is rates. But you can imagine circumstances in which it would be appropriate to have [the two tools] working in what might be seen to be different ways. But that wouldn’t be the case.

Powell sees QT continuing for a while, until the Fed’s balance sheet, at $7.9tn, starts looking a bit more “normal” than it does now. But with the balance sheet still $3.7tn bigger than in 2019, that would take years at the current pace (surveys of traders point to 2025 as an expected end date). But can QT last that long? News coverage inevitably features investors “bracing for turbulence” from QT. Some on Wall Street warn that the Fed is approaching a level where funding market dysfunction is possible. 

It’s not a baseless fear. Remember how QT (more precisely called balance sheet run-off) works. The Fed lets its Treasury holdings expire, without reinvesting the proceeds. Then the Treasury department pays off the bond and the Fed extinguishes that cash. The amount of liquidity in the financial system falls. Right on schedule, balances at the reverse-repo window, the Fed’s bolt-hole for investor cash with no better use, have declined rapidly this year:

Line chart of Amount of cash parked at the Fed's reverse-repo window, $tn showing Beginning of the end

This is only part of the picture, though. In contrast to falling RRP balances, commercial banks’ reserves at the Fed have actually risen this year. This is because RRP transactions (investor buys bonds from the Fed; gets cash) depress reserves. To get a better handle on system liquidity, look more broadly. The sum of bank reserves and RRP balances has declined, but more modestly:

Line chart of Cash balances, $tn showing We've got money coming out of our ears!

How far could the light blue line — a proxy for total system liquidity — decline? The answer is higher than zero. As we discussed with Bill Dudley last week, the Fed wants to maintain an “ample reserves regime”, where the quantity of cash is not a major constraint on the financial system.

The GFC marked the shift from a scarce-reserves to an ample-reserves world. When the Fed flooded the market with liquidity via QE, it became unworkable to manage prevailing interest rates through the old tool: the federal funds rate as managed through the ad hoc buying and selling of Treasury securities. New tools arose. Principally, these were interest paid on excess reserves (IOER) and the RRP. Both are in effect floors on rates. The fed funds rate, meanwhile, has been made obsolete and left in an “undead state”, as Joseph Wang writes in a new post on his Fed Guy blog.

This all matters because it suggests that reserve levels cannot decline beyond a certain point. An ample-reserves regime requires an ample level of reserves, so the Fed’s balance sheet cannot return to any pre-GFC “normal”.

But it still has plenty of room to shrink. As Dallas Fed president Lorie Logan said in a speech on Friday, the Fed’s goal now is moving from “abundant” to merely “ample” reserves. The New York Fed’s rule of thumb is that a reserves level equal to 8 per cent of nominal GDP is too little — the bottom range of “ample”. (Wang explains that this is an imprecise estimate based on the level of reserves during the 2019 repo meltdown.) The chart below shows how far we are from breaching that threshold:

Line chart of Cash balances, $tn showing Far from scarce

Wang, who worked at the New York Fed during the initial rollout of QT, says he is unworried about funding markets breaking down anytime soon, given the Fed’s liquidity facilities and the amount of cash lingering in the system.

What worries him more, though, is the Treasury market. This is the other half of QT: the Fed not only sucks out cash, but ceases buying bonds. The problem is that bond proceeds that would once have been reinvested by the Fed now leave the financial system. The Treasury can no longer count on a certain chunk of its outstanding bonds always being rolled over by the Fed; instead, fresh private buyers must refinance them. Primary dealers expect this will add something like $630bn to Treasury’s private financing needs in 2024, in addition to the $1.8tn needed to finance US deficits.

Disorder in the Treasury market is the one thing that could stop QT’s orderly march to an lower-but-still-ample-reserves world. (Ethan Wu)

Consumer confidence, redux

Yesterday we wrote a piece that should have been called “Could Democratic partisans please, please stop moaning about unhappy consumers”. Most Americans appear to think the economy is pretty bad, despite significant inflation-adjusted growth and high employment. This is unfair to poor Joe, says team Joe. But it just isn’t that surprising: a huge jump in prices like the one we have seen in the past three years leaves people thinking the world has gone crazy, and wondering what awful thing will happen next. A falling rate of inflation, as opposed to falling prices, doesn’t solve the problem. 

This view of things, which we hold strongly, is based in some part on armchair psychology rather than rigorous empiricism. But as if to provide our view with factual grounding, just as our newsletter was publishing the Financial Times published the results of a poll it conducted with the University of Michigan’s Ross School of Business, which found that only 14 per cent of voters think Joe Biden has made them better off. The problem? Inflation, inflation, inflation:

Asked what was the source of their biggest financial stress, 82 per cent of respondents said price increases. Three-quarters of respondents said rising prices posed the most significant threat to the US economy in the next six months. 

“Every group — Democrats, Republicans and independents — list rising prices as by far the biggest economic threat . . . and the biggest source of financial stress,” said Erik Gordon, a professor at Michigan’s Ross School. “That is bad news for Biden, and the more so considering how little he can do to reverse the perception of prices before election day.”

It’s a pretty simple situation! But not completely simple, as Dec Mullarkey of SLC Management pointed out to us. He notes that not all indicators of consumer sentiment agree. Here is the University of Michigan survey of consumers, which we discussed yesterday, and its rival, the Conference Board’s consumer confidence index, over the past 30 years:

The two come apart, and they are about as far apart now as they ever get. Here’s why. Both surveys ask five questions, two about the present and three about the future. The results of the questions about the future render very similar results. The questions about the present do not:

The results are different because the questions are different. Here is what the Michigan survey asks about present conditions:  

We are interested in how people are getting along financially these days. Would you say that you (and your family living there) are better off or worse off financially than you were a year ago?

About the big things people buy for their homes — such as furniture, a refrigerator, stove, television, and things like that. Generally speaking, do you think now is a good or bad time for people to buy major household items?

These questions, crucially, focus on what is going on within the household. Today, they are asking about how the family is doing, and whether it is a good time to buy something big, when the prices of everything are up by at least a fifth versus a few years ago. The answers are predictable. The Conference Board, by contrast, asks about business conditions outside the household:

How would you rate present business conditions in your area?

What would you say about available jobs in your area right now?

Looking outside the home, we think of streets and shops that are busy, and the fact that most everyone is employed. And so the answers are more positive. 

I think it is pretty clear how this will play out in the polling booth. But what about in the stock market? How predictive are sentiment surveys? They are coincident indicators, for the most part, and therefore only useful as part of a larger set of indicators. Here is the year-over-year change in the Michigan survey plotted against the change in the S&P 500. Can you discern a consistent pattern of sentiment predicting market shifts? 

Line chart of Year-over-year change showing Coincidents

Yeah, us neither. 

One good read

Ridiculously expensive clothes.

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