Why the Federal Reserve could be Ending it's Quantitative Tightening Soon: ZE Remarks on Why we think it Should.

By Chinedu Okoye 

As the Fed continues to unwind its balance sheet, the corresponding drain on bank reserves is beginning to show up across short-term funding markets. In these markets, liquidity conditions have tightened, pushing repo rates higher and bank reserves lower — a sign that quantitative tightening may be nearing its limit..

The balance sheet unwind was meant to be a correction of the massive balance sheet expansion seen in the last decade and a half, –quantitative tightening. However this measure has seen liquidity depressed, a steady rise in ultra short-term rates, “as the treasury is rebuilding its cash pile” – to quote Bloomberg's Lisa Cook.¹

This could also be a major factor in the inflation stickiness experienced in the struggle to get it within the feds 2% target.

On Ultra-High Short-term Rate;

Because of this liquidity squeeze; the difference between Secured overnight financing rates (SOFR) and the effective feds funds rate (th benchmark rate of the US Fed), have widened further since December 2024.

This means Short-term rates, on overnight facilities for banks exceed the risk free benchmark, and as a result, “bank reserves fell just below $3 trillion, the lowest level since January, according to the latest data.”

This makes banking reserves “close to becoming merely ample – rather than abundant,” John Velis, at BNY told Bloomberg.¹

This QT, which begam in 2022, and an increase in new debt issuances have been responsible for driving yields up

.

(US Bank Reserve Money)

The market is now begining to feel the liquidity squeeze as inflation bites –reducing the value of money (income/earnings of individuals, nonbank and bank institutions)– and interest rates on mortgages are still relatively high. Hence the draining of banking reserves.

ZE Opinion: Proposed Federal Reserve Policy Action:

The quantitative tightening from ZE lenses should have been the primary tool or major tool in fighting inflation, meaning lesser rate hikes, and an unchanged unwind with a maximum sale and by extension a minimum Federal Reserve Balance sheet size. 

This would have had a quicker effect on prices, as liquidity matters most, seen as American household debt rose and outpaced real wages in the time period. Since liquidity matters more to banks and industry than return on income or interest costs

.

ZE Initial Federal Reserve Monetary Policy Proposition:

The ZE proposition was and is in hindsight, that QT, or Federal Reserve balance sheet unwind, at lower [benchmark] interest rates, would have put a lid on credit-fueled price increases. Meanwhile, growth ornchages in mortgages, sovereign bond yields, and consumer loans would be capped.

This would have done more to stabilise prices without jeopardizing growth as the QT balances the relatively lower rates )from smaller, and less periodic hikes without undue interest cost burden on household and businesses).

But just like anything in Post-Keynesian fashion, there would have to be a limit, and it is on our opinion that the Fed is at or.close to that point. This is no to say that banks are fragile, but that the current policy framework is fragile.

Why Stop, Slow or Fade out QT?

Reasons for the ZE view of yhe necessity of a pause in balance sheet unwinding are as follows;

 1. The value of money injected in 2020, or the years prior, surpasses that of today, without interest, so offloading the same amount, where bank leverage is relatively high, has a real and nominal effect of the decrease in the money supply. Since every cent has a lower eeeal inflation adjusted value, higher interest costs or monetary tightening affects the already depleted objective exchange-value of earnings/cashflows negatively.

 2. This would then weigh on both core and headline inflation, to which the natural response, expectially in this day of AI would be to cut down expenses on the most dispensable factor of production – labor.

Unemployment PMIs in both services and manufacturing for August showed a marked slowdown, with the latter deep into contraction territory suggesting that employers aee weary, especially as the US labor market is still more or less at full employment (4.3% unemployment rate).

 3. If you add to the fact that companies have been taking the tarrif losses head one it becomes all the more glaring how much tighter the liquidity is.

Repos Echoing Liquidity Concerns:

Another signal of worry is the level of interest benchmarks tied to Repos. The article states;

 “Interest-rate benchmarks tied to overnight repurchase agreements collateralized by US Treasuries are hovering around the Fed’s interest on reserve balances rate, known as IORB, an indication that higher funding costs are here to stay.”

Why?

Where there is ample liquidity, the SOFR - feds funds rate would be or interest rate offered on Repo (Repurchase Agreements), hover below the IORB, as banks and other FIs are willing to take a smaller rate of return overnight on a facility secure by the safest asset.

But when liquidity is tight, the SOFR - Fed's funds rate spread widens, and the repo rates come up, to or above the interest on reserve balance (IORB), as banks and other relevant Financial Institutions (FIs) –not excluding retail and individual participation – are more risk averse and demand compensation larger than the interest they'd earn by simply parking their excess reserves at the Federal Reserve.

Hence the current repo rates at,just below or just above the interest on excess reserves (IORB), as SOFR - Fed's funds rate widening, provides further indication that liquidity conditions are tighter than necessary and/or appropriate, and QT has run it's course.

For except the Fed cuts rates aggressively – a scenario not promised given the hawkish sentiment our of the Fed's Presidents, and Chairman Jerome Powell– QT continuance could lead to broader liquidity and (private) credit risks.

ZE Proposed Federal Reserve Policy Action:

Because the fundamentals we watch do not support a massive and rapid Fed rate cut, the Zero Equilibrium proposition is that, QT should be paused, or significantly reduced and even at that, spaces out. As market needs the accomodation they've grown used to, in order to function.

With QT paused, as rates reduces –however marginally or rapidly –systemically,and slower than desired, banks can gradually recoup reserves, and reallocate funds to both industry directly and FI peers (indirectly), and this willingness brings rates on these instruments down.

Another option would be to reduce the interest on reserve balance to zero indefinitely, prompting the injection of banks excess reserves into the economy directly or indirectly (as per the previous paragraph).