How Will Quantitative Tightening Work?

The Fed’s second round of quantitative easing ended in late June. That means we are now in a period of quantitative accommodation. The Fed continues to hold a hefty portfolio of mortgage-backed securities and longer-term Treasuries — thus providing continued, unconventional monetary stimulus — but it’s not adding more.

At the FOMC’s June 21-22 meeting, the members discussed how it would someday exit from this unusual policy posture. In short, the Fed discussed the roadmap for quantitative tightening.

Here’s how it will work:

To begin the process of policy normalization, the Committee will likely first cease reinvesting some or all payments of principal on the securities holdings in the [System Open Market Account].

At the same time or sometime thereafter, the Committee will modify its forward guidance on the path of the federal funds rate and will initiate temporary reserve-draining operations aimed at supporting the implementation of increases in the federal funds rate when appropriate.

When economic conditions warrant, the Committee’s next step in the process of policy normalization will be to begin raising its target for the federal funds rate, and from that point on, changing the level or range of the federal funds rate target will be the primary means of adjusting the stance of monetary policy. During the normalization process, adjustments to the interest rate on excess reserves and to the level of reserves in the banking system will be used to bring the funds rate toward its target.

Sales of agency securities from the SOMA will likely commence sometime after the first increase in the target for the federal funds rate. The timing and pace of sales will be communicated to the public in advance; that pace is anticipated to be relatively gradual and steady, but it could be adjusted up or down in response to material changes in the economic outlook or financial conditions.

Once sales begin, the pace of sales is expected to be aimed at eliminating the SOMA’s holdings of agency securities over a period of three to five years, thereby minimizing the extent to which the SOMA portfolio might affect the allocation of credit across sectors of the economy. Sales at this pace would be expected to normalize the size of the SOMA securities portfolio over a period of two to three years. In particular, the size of the securities portfolio and the associated quantity of bank reserves are expected to be reduced to the smallest levels that would be consistent with the efficient implementation of monetary policy.

Bottom line: (1) stop reinvesting principal on securities (both MBS and Treasuries, presumably), (2) modify guidance about federal funds rate, (3) raise federal funds rate (and interest on reserves), (4) sell agency securities. If I am reading this correctly, selling Treasuries is not part of the exit strategy. The Fed’s Treasury portfolio will thus decline soley as principal payments are made.