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Quantitative tightening: Where are we standing ?

Fed | Economy | Central Banks | Inflation | USA

Fed funds rate

On the 1st of February, the Fed has unsurprisingly announced to raise the key interest rates by 25 bps. The federal funds rate is now set within a target range of 450 to 475 bps. For comparison, a year ago the same rate was in the range of 0 to 25 bps.


Compared to historical tightening cycles, the Fed has been raising rates at a record pace.


After the most recent relatively small interest rate hike, markets are expecting another 25 bps rate hike at the next FOMC meeting. Based on these market expectations, this should be the last rate hike for the year. The markets are anticipating a maximum Fed funds rate of 500 bps and interest rate cuts already near the end of the year.


Also of interest is to observe how the yield curve has changed in the recent past. Not surprisingly, yields on the shorter end of the curve have risen sharply, but at the same time the yield curve has also become highly inverted. These enormous movements are particularly evident when compared to the yield curve from six months ago.


Investors are concerned about an economic recession and are trying to lock in the current yields on long-term US government bonds. This rising demand for longer-term bonds signals risk aversion and provides one explanation for the inverting yield curve.

Balance sheet

In the context of quantitative tightening, the question arises to what extent this change in monetary policy is already reflected in the Fed's balance sheet.

In May 2022, the Fed had released the following statement on reducing its balance sheet:

  • For Treasury securities, the cap will initially be set at $30 billion per month and after three months will increase to $60 billion per month. The decline in holdings of Treasury securities under this monthly cap will include Treasury coupon securities and, to the extent that coupon maturities are less than the monthly cap, Treasury bills.

  • For agency debt and agency mortgage-backed securities, the cap will initially be set at $17.5 billion per month and after three months will increase to $35 billion per month.

These measures are becoming clearly visible in the Fed's huge balance sheet. Since its peak, the Fed's total assets have already declined by more than 500 billion.


Financial Conditions

What might be surprising in the context of this quantitative tightening are the financial conditions. A detailed insight into financial conditions is provided by the Chicago Fed's National Financial Conditions Index (NFCI). Positive NFCI values have historically been associated with tighter than average financial conditions, while negative values have historically been associated with looser than average financial conditions.The NFCI currently stands at -0.35, indicating that recent interest rate hikes have had little impact on it. Out of the 105 indicators used for the calculation, 70 were classified as "loosened" during the past week.


A detailed breakdown of the individual contributions clearly illustrates the state of the financial conditions.


The situation on the lending side, however, is less surprising. The standards for loans have risen significantly as a direct consequence of the tighter monetary policy.


Part 2 will follow next week...

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