A Monetary Deep Dive
#115: Charting the path forward.
Ostensibly, we are on the cusp of a new monetary easing cycle. In September, the Federal Reserve’s Open Market Committee (FOMC) will likely cut interest rates for the first time since March 2020. With inflationary pressures subsiding and the labor market weakening, most agree that the time has come to pivot.
But the reality is that the easing cycle is already well underway.
Even as the Fed’s two primary policy levers — balance sheet and interest rates — appear to be restrictive, a closer inspection reveals a more complex picture. In both aspects, I argue that peak tightness occurred in late 2022, and that monetary policy has been gradually easing for well over a year. The upcoming rate cuts are merely the follow-through as the Fed attempts to stick the elusive soft-landing.
This week, I dive back into the deep end of monetary mechanics and where we are heading.
Balance Sheet Dynamics
Interest Rate Dynamics
Monetary Aggregates and Capital Formation
The Path Forward
The Balance Sheet
Perhaps the most critical role of the Federal Reserve is controlling the supply of money. The Fed determines the amount of actual dollars in circulation — base money — with its balance sheet policy, while also directly and indirectly influencing broader measures of money supply like M2.
First, a quick refresher on how many actual dollars exist, where they reside, and how they function in financial markets. By breaking down the liabilities of the Federal Reserve into its components, we can establish a framework that I find helpful in understanding the mechanics of policy.
Most base dollars exist as either physical currency (paper and coin) or bank reserves — i.e. cash held by the commercial banking sector. These two categories equal the monetary base, which we can think of as high-velocity dollars held1 by banks and individuals.
Outside of the banking system, several important entities store dollars directly in accounts at the Fed. The U.S. Treasury holds the federal government’s cash in the Treasury General Account (TGA), and money market funds (MMFs) have access to the Reverse Repo Facility (RRP). The dollars in the TGA and RRP are still owned by outside parties, and in the case of the RRP earn interest. But these dollars are removed from the financial system — they don’t circulate in the same way and do not add liquidity to the banking sector. They are low-velocity, “trapped” or “sidelined” cash.
This distinction has significant implications for the liquidity and leverage of the banking sector, money aggregates, and practical impact of monetary policy.
Splitting the Fed’s total liabilities across these categories looks like this.
Quantitative Easing and Tightening
The total dollars outstanding — i.e. the Fed’s total balance sheet — is influenced by the Federal Reserve’s active monetary policy, as well as private participants’ demand for liquidity.
When private parties choose to borrow from the Fed’s lending facilities like the discount window, more base money is created and the balance sheet grows. We can see the bump in early 2023 as bank borrowing spiked with the Silicon Valley Bank collapse and the establishment of the Bank Term Funding Program.
But the key driver of changes in base money is the Fed’s large-scale bond purchases and sales, quantitative easing (QE) and quantitative tightening (QT). Given that all other money-derivatives like bank deposits or Treasuries represent claims on base dollars, managing this supply is a critical aspect of monetary policy.
As we see in the chart above, after the initial surge of emergency QE in the pandemic the total supply of base money has followed a fairly neat arc. The balance sheet grew at the consistent pace of QE through March 2022, and began shrinking when QT began in June 2022. Today, we remain in a period of base money contraction. Via QT, the Fed continues to shred dollars daily, reducing both base money and overall broad money supply. Reducing money supply slows economic activity and inflation.
In June, the Fed made its first adjustment to balance sheet policy in two years by reducing the pace of QT from a maximum of $95 billion per month to $60 billion per month. (The actual pace of QT has shifted from ~$75 billion to ~$40 billion monthly.) This shift was likely made with both bank reserve adequacy and directional policy in mind.
For all the focus on interest rates, there is surprisingly little discussion of the Fed’s plans for the balance sheet. Commentary by Fed officials suggests that the Fed may continue to shrink the balance sheet even after cutting interest rates.
Yet, even as QT continues to reduce the total supply of dollars, actual monetary conditions have eased…
The Reverse Repo
The RRP enforces the Federal Reserve’s interest rate objectives by providing an unlimited bid for dollars within the band of the Federal Funds target. As shown below, the RRP has successfully guided short-term interest rates for both secured overnight financing (SOFR) as well as short-term Treasury bills.
The RRP is the “plug” between the two hardcoded levers of monetary policy — the size of the balance sheet and interest rate target. If too much money in financial markets causes rates to fall below the Fed’s target, the RRP removes that excess liquidity (subject to counterparty limits). If too little money causes interest rates to rise above the RRP award rate, then funds flow back into the commercial banking and broader financial ecosystem (subject to available RRP balances).
This counterbalancing force has been critical in the past several years. Increases in RRP counterparty limits and the award rate in 2021 led to a flood of cash out of the financial sector and into the RRP facility, absorbing and offsetting much of the Fed’s QE from mid 2021-2022. Then in 2023, the RRP became a massive source of liquidity, returning cash to private hands. As we outlined in Repo to the Rescue, the $2 trillion drain of the RRP was large enough to offset the TGA rebuild and QT with even a bit left over.
Over the past several months, the RRP drain has dwindled to a dribble (astutely predicted by ). The facility currently holds a balance of $400 billion, which continues to peg short term interest rates while theoretically providing funding for another 10 months of QT while holding the monetary base stable.
But the RRP can only serve its purpose of regulating rates if there is cash available to draw. As the RRP’s tank runs towards empty, it will put more pressure on the Fed to reduce or pause QT.
Treasury General Account
The Treasury General Account aggregates the federal government’s inflows (tax receipts and debt proceeds) and outlays (spending and debt payments). Despite its real impact on the monetary base and broad money supply, this factor is divorced from active monetary policy and is instead a product of congressional haggling.