How will the Federal Reserve end its monetary tightening program?

The U.S. Federal Reserve has initiated a review of the possibility of gradually withdrawing from its monetary tightening efforts,
which began two years ago to remove trillions of dollars added to the financial system during the COVID-19 pandemic.
This tightening aims to withdraw excess liquidity from the system and avoid financial disruptions.
Despite the willingness to halt these efforts, the timeline for its conclusion is unclear,
creating divergence among market participants about its continuity without causing significant financial disruptions.

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Monetary tightening is a counteractive move to quantitative easing policy, where the Federal Reserve withdraws additional financial flows from the markets by reducing its holdings of bonds. Practically, it allows bonds to mature without replacing them, gradually removing liquidity.

The current monetary tightening policy of the Federal Reserve involves reducing its holdings at a rate of $95 billion per month, presenting new bonds at a rate of $60 billion, and mortgage-backed securities at a rate of $35 billion monthly as well. This reduction demonstrates increased effectiveness compared to the previous period of monetary tightening.

Regarding the impact of tightening on bank reserves, significant effects have not occurred thus far. The reverse repo mechanism has continued to shrink due to the tightening period, not directly linked to reserves. With continued tightening, it may lead to a reduction in reserves over time.

The impact of the Federal Reserve’s monetary tightening on the U.S. economy has not been without consequences. Regardless of the source of liquidity drainage – whether reserves or reverse repo – this process has affected the Treasury Department, which is forced to borrow more money from the public, leading to increased borrowing costs. While quantitative easing led to a decline in interest rates, monetary tightening is expected to raise them. Despite a decline in bond yields in October due to expectations of easing monetary policy, concerns about the size of federal borrowing, partly influenced by monetary tightening, led to an increase in interest rates last fall.

The worst-case scenario may repeat itself, as the previous experience in December 2018 showed a negative impact on the stock market when Federal Reserve Chairman Jerome Powell indicated a continuation of tightening policy. It appears that insufficient banking reserves in the system could be a problem, indicating the need to plan for a gradual exit from monetary tightening.

Policymakers are now seeking to avoid previous disruptions by designing a plan for the gradual exit from monetary tightening, which may include explicit announcements or discussions of general criteria.

How will the Federal Reserve end its monetary tightening program?

How will the Federal Reserve end its monetary tightening program?

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