As Fed mulls the end of QT, what lessons have been learned?

• Key Insight: Market watchers expect the central bank to announce an end to its QT program soon, signaling the close of the Fed's large-scale asset purchases during the pandemic. Economists have varying feelings about the program, with some urging the Fed to reconsider future purchases of mortgage-backed securities.
• Expert Quote: "You can argue about whether it's good or not. I think it's OK to do emergency things in times of crisis, but you have to stop doing them when the crisis is over." — Alex Pollock, senior fellow, Mises Institute.
• What's at stake: Critics of the Fed's QE program in 2020 say its aftermath contributed to rising home prices and worsening affordability.

As the Federal Open Market Committee is slated to announce its near-term interest rate decision later today, market watchers are also expecting an announcement about when the central bank will stop allowing securities on its balance sheet to mature.

The looming end of the Federal Reserve's most recent foray into large-scale asset purchases as a function of monetary policy — a process known as "quantitative easing," or QE, when the Fed is adding to its balance sheet and "quantitative tightening," or QT, as it draws its balance sheet back down again — is spurring many financial experts to reassess the utility of the program and what lessons might guide the central bank on its use in the future.

Federal Reserve Chair Jerome Powell said in a recent speech that the central bank's "long-stated plan" is to stop balance sheet runoff in the coming months. The Fed began engaging in QE at the onset of the Covid pandemic in 2020, but quickly shifted tactics in mid-2022 in response to surging inflation by hiking interest rates up significantly and immediately reducing its balance sheet. 

Many economists expect the Fed will announce the end of QT soon — perhaps as early as Wednesday. Mike Wilson, chief investment officer at Morgan Stanley, said in a podcast this week that he expects the Fed will hold off until after the new year to announce the end of QT.

"There is a growing consensus view for the Fed to announce the end of QT but uncertainty around the timing," said Wilson. "Our house view is for the Fed to wait until the January meeting to make this official with an end of the program in February. Others believe the Fed could announce something as early as this week."

Most market watchers agree that QE can be useful during economic stress. Where they differ is on when and how aggressively the central bank should use it.

"You can argue about whether it's good or not," said Alex Pollock, senior fellow at Mises Institute. "I think it's OK to do emergency things in times of crisis, but you have to stop doing them when the crisis is over." 

The MBS problem

Debate over the Fed's monetary policy tools intensified following its large-scale purchases of mortgage-backed securities, or MBS, during the pandemic to support the housing market.

From 2020 to 2022, the Fed's MBS holdings more than doubled during the next two years, peaking at $2.7 trillion before the Fed began allowing the assets to roll off their books. It contributed, some say, to imbalances in the housing market, as interest rates fell sharply and a home-buying frenzy ensued, ultimately driving up home prices and worsening affordability.

A recent paper penned by Brooking's Institution's senior fellow Aaron Klein argues that the Fed's MBS purchases may have contributed to housing inflation.

"The Federal Reserve needs to reconsider how it operates QE, taking into account the impact of purchasing MBS on the housing market and the feedback loop between housing and inflation," Klein's recent paper argues. "Housing is the largest component of inflation, itself meriting special attention."

Powell acknowledges Fed could have ended Covid-era QE sooner

Federal Reserve Chair Jerome Powell acknowledged skepticism around the central banks large-scale asset purchases during the pandemic, noting the Fed likely "should have stopped" sooner, but fell short of admitting that the purchase of MBS' contributed to housing disparities.

Pollock commented that the Fed's purchases of Treasuries and MBS "caused a bubble in the bond market" and that they should've tapered off QE more quickly.

"The Fed caused a bubble in the housing market, led the banking system into enormous interest rate risk as the pied piper," said Pollock. "In my judgement, the Federal Reserve should own exactly zero mortgage assets. They had no business … subsidizing mortgages, manipulating mortgage prices, and therefore house prices. They ought to go back to zero mortgages."

Derek Tang, CEO of Monetary Policy Analytics, said "MBS buying has always been an issue for the Fed," because unlike Treasuries, MBS is not sector-neutral.

"However, if crises get big enough like the [Global Financial Crises] and Covid, if the Fed is buying Treasuries anyway, it really has to buy MBS too to get the desired effect on the Treasuries market since the trading is linked," Tang said. "One way for the Fed to avoid MBS buying in the future is if Treasury or [Fannie Mae and Freddie Mac] do it instead."

QE and political pressure

Though the Fed has only engaged in large-scale asset purchases during periods of economic stress — and even that is only fairly recent — some analysts have concerns that the central bank could be pushed to act outside of historical norms to prop up the economy. Doing so, some warn, could put the Fed's independence at risk.

According to Tang, the Fed might face pressure to "help out" if long-term Treasury yields spike, increasing the cost to borrow money.

"The more the Fed is involved in money markets, the more the White House might think, 'The Fed is clearly able to intervene, so the question is whether the Fed is willing to,' and that issue quickly becomes a question of political choice," said Tang. "That would put the Fed in a very awkward position." Mark Zandi, chief economist at Moody's Analytics, expressed a similar concern. 

He said that if the Fed starts buying bonds for reasons unrelated to its dual mandate and when rates are not at the zero lower bound, "that's a problem." 

"I think that may be an issue in the future," Zandi predicted.

But those cautions do not mean there is no role for QE in monetary policy, Zandi said, adding that if the Fed is buying bonds, rates are near-zero and the economy is still struggling, then it is "entirely appropriate for them to use QE in the way that it's designed: by buying government-backed securities."

Does QE work?

The subject of the central bank's balance sheet and how it ties into monetary policy going forward was a topic recently raised by Treasury Secretary Scott Bessent. In a recent op-ed, Bessent argued that the Fed's "heavy intervention" in financial markets has led to "unintended consequences," raising the question of whether QE should be used going forward.

Bessent said that the central bank's "wall of liquidity" flattened the cost of capital across industries and drowned out the market's ability to send early warning signals when "the real economy shows signs of weakening or of rising inflation."

"Looking ahead, it is essential the Fed commit to scaling back its distortionary impact on markets," Bessent wrote. "At a minimum, this likely includes the Fed only using, and then halting, unconventional policies like QE in true emergencies and in coordination with the rest of government."

Whether the tool requires an overhaul has long been debated, with a 2016 paper from the Federal Reserve Bank of Philadelphia noting that there is "significant uncertainty about the size of the effects of QE and the channels through which it operated."

Nonetheless, Zandi said the utility of QE is in significant part attributable to the signal of support that it sends to long-term bond investors, and the strength of that signal is in persuading those bond buyers that the central bank will protect their investments. Sending that signal is crucial to any effort by the Fed to manage an economic crisis, he said.

"[During QE] the Fed is signaling to investors that it wants to push the rates lower and will continue to be aggressive in keeping rates down, and that signaling is the reason why investors say, 'OK, I'll buy bonds because the Fed's got my back,' and therefore that brings down long-term interest rates," he said. "I view it just as standard monetary policy, just the next thing you do when you hit the zero lower bound."