Quantitative Tightening: How the Fed Could Fight Inflation Without Raising Rates

The last decade of monetary policy was defined by quantitative easing (QE). This was designed by the Federal Reserve and other central banks to stimulate the economy in a zero interest rate world.

The mechanics of this effort entailed central banks buying up assets such as Treasuries, mortgage-backed securities (MBS), corporate bonds, and stocks, in some instances.

By buying up these assets and essentially removing them from the economy, central banks were increasing liquidity in the system. It's unclear what impact it did have on the economy, but it certainly had a very material impact on risk appetites which do have an inadvertent effect on the economy through the 'wealth effect'.

While there certainly is a valid criticism of these efforts, it was successful in preventing a deflationary spiral as was commonly feared during the Great Recession. Further, the worst-case fears of a hyperinflationary spiral never materialized as well.

Now, the situation is much different as persistent inflation is the economy's major threat. The obvious tool to combat this is to raise rates which the Fed is moving towards. But, this has a drawback in that it would slow the economy. The Fed has a dual mandate - boosting employment and stable prices. Of course, there's somewhat of a tradeoff between these 2 in that fighting inflation has the collateral effect of slowing the economy and reducing employment.

But, the Fed's major balance sheet expansion has also unlocked another potential tool for the central bank which is quantitative tightening (QT) or the inverse of QE.

QT means the Fed would reduce its balance sheet by selling assets and in effect, removing liquidity from the system. Just like QE had a stimulatory effect on the "financial economy" while having a mild effect on the "real economy", it's likely that QT would have a dampening effect on the "financial economy" while not affecting the "real economy".

In terms of market implications, I'd expect a chilling effect on high-multiple, growth stocks which are the most sensitive to fluctuations in liquidity. At the same time, it should benefit value and cyclical stocks which are more tied to the actual economy.