E Why The Fed Is Hesitating On Continuing With Quantitative Tightening

While Fed watchers focussed on yesterday’s announcement of a pause in the rate cycle increases, the more important statement by Chairman Powell concerns the process of “quantitative tightening”. This is the process of steadily shrinking the Fed’s balance sheet from its peak of $4 trillion by not purchasing U.S. Treasuries upon maturity. The Fed will continue for now but it will end the program sooner than expected. Furthermore, he hinted that the size of the balance sheet could be “an active tool” in the future. That is, more bond purchases could take place should the markets or the economy require new stimulus. This is a major departure in recent Fed policy since the Fed has up to now insisted that the balance-sheet shrinkage was to continue regardless of any changes in interest rates. Why did the Fed take quantitative easing off autopilot?

The simple answer lies in the fact the monetary base and excess reserves began to decline in the summer of 2014. The monetary base is the total amount of a currency that is either in general circulation in the hands of the public or in the commercial bank deposits. The monetary base is sometimes referred to as “high powered money”. It is called high-powered because an increase in the monetary base can lead to a bigger proportional increase in the overall money supply, the principal source of bank credit that allows an economy to grow. Consequently, shrinking the monetary base has led to a pronounced flattening in the U.S. Treasury yield curve and, perhaps more importantly, a retrenchment in world dollar liquidity[1]. Following the financial collapse in 2008, commercial banks have been very reluctant to lend money and so the increase in the monetary base didn’t lead to greater credit creation. But it did lead to an increase in bank reserves which added to the tightening credit conditions. Although reserves have been falling, this insufficient to offset the bigger problem of a shrinking monetary base---- simply, credit is tightening to the detriment of economic growth.

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