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The 21st Century Fed - Not your Mother's or Father's Federal Reserve

March 1, 2023 | Commentary

  • The fight to reduce annual inflation back toward 2% is the Fed’s current top priority.  Tools at work include increases in the Fed Funds rate and a reduction in the Fed balance sheet, commonly known as Quantitative Tightening or QT.
  • Quantitative Easing, or QE, began in the wake of the Great Financial Crisis (GFC) and accelerated in the COVID shutdowns and recession.  It is tempting to think that since on average the period of QE was favorable to risk assets like stocks, QT must be bad.  The relationship is more nuanced than that.
  • The liability side of the Fed’s balance sheet now includes major items that were never significant before the GFC.  Increases in reserves held at the Fed, reverse repos and the Federal Government’s own checking account have acted as counterbalances to the massive growth in assets due to QE.  Just as they restrained inflationary growth during QE, they are acting as a rein on the worst potential outcomes one might expect from QT.
  • The Fed’s main tool against inflation will continue to be the level and duration of higher Fed Funds interest rates.  Uncertainty about this alone adds volatility to risk markets.  The last 13 years have shown that the Fed can manage its balance sheet in ways unimagined before the GFC.  Investors looking at the Fed through a 20th Century lens are likely to err in their interpretation of the bank’s actions.

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