Quantitative Tightening: Definition, What It Is, When It Starts, How It Works

Starting in June 2022, the Federal Reserve began a program known as Quantitative Tightening (QT). It is a process through which the Fed shrinks its balance sheet. For most people, the news may not sound like a big deal. However, it is crucial to understand how it impacts the economy. It is also critical to discuss the Fed balance sheet before quantitative tightening.

How does the Federal Reserve Balance Sheet work?

The Federal Reserve balance sheet resembles the statement for other entities. It includes an asset and liabilities section. On the assets side, the balance sheet primarily consists of treasury securities and mortgage-backed securities. Besides that, the Federal Reserve balance sheet also includes other resources. Generally, any purchases made by the Fed become an asset.

The liabilities section primarily includes bank reserve and the US currency in circulation. The former is the most prominent obligation on the Federal Reserve balance sheet. Apart from these, the statement also includes other liabilities, including reverse repurchase agreements. Together, these liabilities and assets constitute the Federal Reserve balance sheet.

What does Federal Reserve Balance Sheet Expansion mean?

The quantitative tightening concept closely relates to balance sheet expansion. Essentially, it represents a monetary policy introduced by the central bank. In this policy, the Fed acquires assets to expand its balance sheet on a large scale. This strategy involves purchasing long-term securities and lowering long-term interest rates.

The Federal Reserve used balance sheet expansion as a policy to introduce a looser monetary policy during the COVID-19 pandemic. During this process, the Fed acquired over $4 trillion in assets. This policy allowed the Fed to stimulate the economy and encourage economic activity. In May 2022, however, the Federal Reserve decided to use quantitative tightening to control it.

What is Quantitative Tightening?

Essentially, quantitative tightening is the opposite of balance sheet expansion. In this process, the Federal Reserve disposes of its assets. This process is also known as balance sheet normalization. Quantitative tightening is a monetary policy to reduce the reinvestment process. This process continues until the balance sheet becomes normal again. The plan used to execute this strategy comes from the Federal Reserve itself.

Essentially, quantitative tightening involves reducing the money supply within an economy. This step allows the Federal Reserve to normalize the economy. Although it may sound like it impacts the economy adversely, quantitative easing does not oppose the impact of balance sheet expansion. It can cause positive changes in the economy as well.

How does Quantitative Tightening work?

The Federal Reserve can stimulate the economy through balance sheet expansion. However, quantitative easing can also impact the economy positively. Usually, the central bank uses this strategy as a long-term approach to normalizing its balance sheet and the economy. During this process, the Federal Reserve targets the supply of monetary reserves within the economy.

Usually, quantitative tightening involves letting previously acquired assets reach their maturity. These assets include bonds and other securities. Consequently, these assets get removed from cash balances. Sometimes, it also involves increasing interest rates to reduce the money supply within the economy. This process continues until the Fed decides its balance sheet has normalized.

Conclusion

The central bank may use different monetary policies to stimulate the economy. Usually, it uses balance sheet expansion to acquire assets and help with economic growth. In contrast, the Fed can utilize quantitative tightening to normalize its balance sheet. This process involves unloading assets previously created through balance sheet expansion.

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