Fed Balance Sheet Reductions: What it Means for Business

A stack of financial papers with the words ‘financial balance sheet’ a pen and some cash

By most measures, the economy has recovered from the worst effects of the pandemic and subsequent recession. As inflation persists, many fear that price increases could become permanent, without prompt intervention from the Fed. The Fed has already taken action to fight inflation by raising rates twice since the start of 2022.

In addition to interest rate policy, the Fed began reducing the size of the balance sheet in a process called quantitative tightening. This process began on June 1st, and it’s important for business leaders to understand its impact.

What is Quantitative Tightening?

In simple terms, quantitative tightening is the opposite of quantitative easing. When the economy is struggling, the Fed can engage in quantitative easing—or the large-scale purchase of Treasury instruments, mortgage-backed securities, or other assets. This process adds to the money supply, increases liquidity in markets, and can help lower or stabilize market interest rates.

When the economy has recovered, or is overheating, the Fed can reverse the purchases made under a quantitative easing program and begin quantitative tightening. This is intended to have the opposite effect on the economy – decreasing the money supply, reducing market liquidity, or allowing markets a bigger role in determining rates.

The most recent round of quantitative easing began in March 2020 in response to the COVID-19 pandemic and subsequent recession. The purchases wound down throughout the winter of 2021 and finally concluded in the spring of 2022. Now, with the economy recovered from the worst effects of the pandemic, and inflation continuing to plague consumers, the Fed will begin unwinding the purchases made under the quantitative easing program.

To accomplish quantitative tightening, the Fed limits reinvestments into the securities purchased under quantitative easing. Starting June 1, only principal payments that exceed a monthly cap will be reinvested. For Treasuries, the initial cap is set at $30 billion per month and that will be increased to $60 billion after 3 months. For agency and mortgage-backed securities, the cap has been initially set at $17.5 billion per month and will increase to $35 billion after 3 months.

Implications of Quantitative Tightening for Businesses

The Fed influences the economy through the affordability of credit. When interest rates are low, and there is more money in circulation, consumers and businesses are incentivized to borrow money. These funds are often used to purchase long-term goods, and fund expansionary projects for businesses which can lead to strong economic growth. However, when the economy is overheating, and inflation is running rampant, the Fed can raise rates and implement quantitative tightening to make credit more expensive, thereby slowing economic growth. Generally, quantitative tightening leads to the following.

Lower Money Supply

When the Fed engages in quantitative easing, they create the money that they use to buy the securities. This is usually referred to as ‘printing money’ though in today’s world it happens electronically.

When quantitative tightening takes place, it reverses a previous quantitative easing program and the funds that were created are destroyed. This reduces the amount of money in circulation.

The money supply has an inverse relationship with interest rates. When there is more money in the economy, banks generally have more funds to lend, which drives down interest rates. On the other hand, during quantitative tightening, the reduced money supply lowers the amount of funds available for banks to lend and can therefore drive an increase in market interest rates.

Higher Interest Rates

As rates increase, the monthly payments on new business loans often rise in tandem. This can mean that businesses no longer qualify for loans at the new, higher rates. Additionally, businesses may find it difficult to afford payments at the higher rates and these higher payments can make some projects unfeasible that otherwise would have moved forward.

When projects become more difficult and expensive to finance, businesses could find their options for expansion shrinking. In this case, leaders often choose to fund what purchases they can with cash reserves rather than financing.

While many tend to focus on the negative ramifications of rising rates, there are positive outcomes as well. One of these is that the rate of return that businesses earn on their investments could increase with interest rates. As quantitative tightening pushes interest rates higher, businesses could also expect to earn more on their bond investments. Since market interest rates are often aligned, higher yields on bonds can have spillover effects into other areas, like deposit rates. This could mean that business cash reserves earn more in the future, though there are many other factors at play.

Increased Duration Risk Premium

The Fed typically buys longer-term bonds under quantitative easing. This creates demand for these securities and reduces the risk premium associated with them. On the other hand, when the Fed sells these securities, it reduces demand in those areas and can drive up the risk premium. For businesses that issue bonds, this could mean that they must pay higher yields on the bonds they issue. This added expense can increase the cost of raising money by issuing bonds.

Tighter Policy Ahead

One often overlooked outcome of quantitative tightening is its impact on consumer expectations, which play a large role in determining market interest rates. Quantitative tightening signals that the Fed is serious about tightening monetary policy. So, if consumers expect the Fed to continue to fight inflation through quantitative tightening and higher rates, market interest rates could continue to climb – raising borrowing costs for businesses.

How Businesses Can Respond to the Effects of Quantitative Tightening

The purpose of quantitative tightening is to further the Fed’s goal of raising rates and slowing economic growth. So, when quantitative tightening is implemented, it serves its purpose by raising the cost of borrowing and therefore slowing investment. However, this is often at odds with a business’ goals of expansion and profitability.

Secure Financing

Businesses often need to fund large projects to maintain their market share, increase their efficiency, and drive profitability. So, those that are planning large purchases should consider moving forward with these projects to avoid higher financing costs in the future. According to the most recent projections, the FOMC plans to continue raising rates throughout the year. So, expect financing to become increasingly expensive over the coming months.

Issue Bonds

Similarly, businesses that plan to issue bonds in order to fund their projects could consider moving forward. The effects of quantitative tightening and rising rates are expected to increase over the near term, so acting now could reduce the overall cost of the bond issue.

Cash Over Credit

As financing becomes more expensive, businesses may shift to using cash to fund expansionary activities, and that often means larger cash reserves. As market interest rates rise, businesses could expect to earn more on these reserves and the interest earned on this cash can help drive additional profitability. However, it can be difficult to find banks offering the most competitive rates.

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