No flip of a switch

By Jeff Huther
ABA DataBank

In response to the financial market turmoil brought about by the pandemic, the Federal Reserve bought almost $5 trillion in Treasury securities and mortgage-backed securities in an effort to support the economy. Those purchases, known as “quantitative easing,” had a direct effect on bank balance sheets: when the Fed buys securities, it increases the sellers’ deposits (liability-side) and the reserves of the sellers’ banks (asset-side). In 2022, the Fed began letting some of its securities mature rather than reinvesting the proceeds into new securities, referred to as “quantitative tightening.” When it comes to how bank balance sheets are affected by the Fed’s actions, QT differs from QE in significant ways. This DataBank explains those differences and highlights  how QT is likely to increase the volatility of benchmark overnight funding rates, such as the federal funds rate and the secured overnight financing rate (SOFR), particularly on the days in the month when reserves are directly affected by QT.

Quantitative easing

Between mid-March 2020 and mid-June 2020, the Fed bought almost $3 trillion in existing Treasury securities and MBS via the secondary market. The sellers were the Fed’s 24 primary dealers, mostly dealer arms of global banks. Intermediation by those dealers had been impaired because massive selling of securities, triggered by pandemic panic, had bloated their balance sheets, limiting their capacity for additional intermediation, even of high-quality assets. As the panic subsided, the Fed slowed purchases but continued to buy around $2 trillion more until the first quarter of 2022, eventually building up its balance sheet from about $4 trillion at the end of 2019 to $9 trillion with large flow-on effects for banks, doubling the amount of reserves and contributing to a multi-trillion dollar increase in deposits.

The Fed buys securities from dealers who solicit offers to sell from their customers (Figure 1, upper half). The Fed’s balance sheet expands, adding securities to its assets and reserves to its liabilities, while the investor’s bank adds reserves to its assets and deposits to its liabilities (Figure 1, lower half).

Figure 1:  The Fed’s Purchases of Securities and Balance Sheet Impacts

When the Fed buys securities in the secondary market, it follows market conventions for settlement. Treasury securities are delivered the day after the purchase and so, since the Fed conducted operations throughout each month, reserves and deposits rise steadily.   MBS settlement is more complicated, with the Fed purchases generally hitting bank balance sheets only a couple of times a month.

Quantitative tightening

The direct effects of the Fed’s purchases of securities in secondary markets are the same regardless of the type of security bought. When the Fed lets its holdings run off, however, the direct effects differ significantly by security type. Maturing Treasury securities require the Treasury to issue more debt to the public or operate with lower cash balances. And repaid principal of MBS is commonly the result of homeowners refinancing their mortgages or taking out new mortgages on different houses.

When the Fed’s Treasury holdings mature, the security is returned to the Treasury (Figure 2, upper half) and the Fed reduces Treasury’s account balance at the Fed, known as the Treasury General Account or TGA (Figure 2, lower half). Unlike QE purchases, there is no direct effect on bank deposits or reserves.

Figure 2:  The Fed’s Runoff of Treasury Securities

Typically, Treasury would need to increase debt issuance to compensate for the outflow of funds from the Fed’s maturing securities. This is illustrated in the top half of Figure 3. Additional issuance causes bank reserves to fall as the investors’ deposits shift to the TGA (Figure 3, lower half).

Figure 3:  Treasury’s Financing from the Private Sector and Balance Sheet Impacts

The Fed’s MBS runoffs reduce bank reserves through the housing agencies. Banks generally send principal and interest payments to Fannie Mae and Freddie Mac on the 18th of each month, creating a reduction in their reserve balances at the Fed. Fannie and Freddie may then leave the money in deposit accounts at the few banks that hold their deposits (temporarily increasing those banks’ reserves) or lend to the Fed through its overnight reverse repo (ONRRP) facility (making the reserve reduction permanent). This is illustrated in the top half of Figure 4.

Figure 4:  The Fed’s Monthly Receipt of MBS Principal Payments and Balance Sheet Impacts

Regardless of Fannie’s and Freddie’s investment choices, they need to have the funds in their Fed accounts by the morning of the 25th of the month, when principal and interest payments are disbursed. At that time, the Fed’s MBS holdings fall and reserves decline (Figure 4, lower half). (Note that repayment of principal of Ginnie Mae securities is more direct: banks make principal and interest payments on the 20th of each month and the payments that go to the Fed directly reduce reserves.)

Why this matters

Going forward, QT is reaching the point where banks will face a dwindling supply of reserves. The operational details of QT will lead to concentrations of reserve reductions on particular days (particularly on Treasury refunding dates at mid-month and month end and when MBS principal payments leave the banking system), which will lead to more volatility in key benchmark rates (such as SOFR) that could reverberate through funding markets. These dynamics will likely be closely watched by the Fed and market participants as QT continues to play out.

Jeff Huther is an economist. He recently retired as VP for banking and economic research in ABA’s Office of the Chief Economist.

For additional research and analysis from the Office of the Chief Economist, please see the OCE website.