On paper, the Fed is shrinking its balance sheet to cool the economy (quantitative tightening). In reality, rate cuts and other channels are injecting liquidity into the financial system faster than it's being removed. This contradictory policy means that despite official tightening, actual liquidity conditions are already easing, fueling asset prices.
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The Fed's intervention in funding markets, while not officially labeled Quantitative Easing, directly helps the Treasury finance its debt, effectively monetizing it and providing critical liquidity to markets.
Recent increases in funding market spreads suggest banking reserves may be too restrictive. This puts pressure on the Federal Reserve to end its balance sheet runoff (QT) sooner than its official timeline, creating a potential for market disappointment if the Fed delays its decision.
The common narrative of the Federal Reserve implementing Quantitative Tightening (QT) is misleading. The US has actually been injecting liquidity through less obvious channels. The real tightening may only be starting now as these methods are exhausted, signaling a significant, under-the-radar policy shift.
The impending halt of the Fed's balance sheet reduction (QT) is not a reaction to a major economic crisis, but a technical necessity to prevent stress in short-term funding markets as bank reserves become scarce. The Fed is preemptively avoiding a 2019-style repo spike, signaling a quiet return to mild balance sheet expansion.
Due to massive government debt, the Fed's tools work paradoxically. Raising rates increases the deficit via higher interest payments, which is stimulative. Cutting rates is also inherently stimulative. The Fed is no longer controlling inflation but merely choosing the path through which it occurs.
Recent spikes in repo rates show funding markets are now highly sensitive to new collateral. The dwindling overnight Reverse Repo (RRP) facility, once a key buffer, is no longer absorbing shocks, indicating liquidity has tightened significantly and Quantitative Tightening (QT) has reached its practical limit.
The Federal Reserve’s recent policy shift is not a full-blown move to an expansionary stance. It's a 'recalibration' away from a restrictive policy focused solely on inflation toward a more neutral one that equally weighs the risks to both inflation and the labor market.
Over the past few years, the Treasury Department and the Federal Reserve have been working at cross-purposes. While the Fed attempted to remove liquidity from the system via quantitative tightening, the Treasury effectively reinjected it by drawing down its reverse repo facility and focusing issuance on T-bills.
Despite low unemployment and high inflation, the Fed is cutting rates to preempt a potential job market slowdown. This "run hot" strategy could accelerate an economy already showing signs of heat from high valuations and low credit spreads, creating significant risk.
The massive increase in government debt held privately has broken the monetary policy transmission mechanism. When the Fed raises rates, the private sector's interest income from Treasury holdings now rises significantly, creating a stimulus that counteracts the tightening effect on borrowing costs.
