By most measures, the economy recovered from the worst effects of the pandemic and subsequent recession by the summer of 2022. However, inflation persisted and many feared that price increases would become permanent without prompt intervention from the Fed. This intervention came in two main parts – higher interest rates and a smaller balance sheet.
Balance sheet reductions – also called quantitative tightening – began in June 2022 and have continued since that time. As the Fed continues to reduce its asset holdings, businesses need to understand the potential implications.
What is Quantitative Tightening?
Quantitative tightening, sometimes called QT, occurs when the Fed reduces the size of its balance sheet. This means they are selling assets typically purchased during a period of quantitative easing, or QE.
When the economy is struggling, the Fed can engage in quantitative easing – 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 stabilize market interest rates and asset prices.
When the economy has recovered – or is overheating – the Fed can reverse its previous purchases through quantitative tightening. This is intended to have the opposite effect on the economy – decreasing the money supply, reducing market liquidity, and allowing market forces to play a bigger role in determining interest rates and asset prices.
Quantitative Easing and Tightening Surrounding the COVID-19 Pandemic
The most recent round of quantitative easing began in March 2020 in response to the COVID-19 pandemic and subsequent recession. These asset purchases slowed throughout the winter of 2021 and finally concluded in the spring of 2022.
The Fed began quantitative tightening in June 2022. To accomplish their goals, they limited reinvestments into the securities purchased under quantitative easing above a set monthly cap. For Treasuries, the initial cap was set at $30 billion per month and was increased to $60 billion after 3 months. For agency and mortgage-backed securities, the cap was initially set at $17.5 billion per month and increased to $35 billion after 3 months. The higher caps are still in effect as of September 2023.
Implications of Quantitative Tightening for Businesses
Both quantitative easing and quantitative tightening influence the affordability of credit. Quantitative easing tends to make borrowing less expensive while quantitative tightening tends to make credit more expensive. This process often leads to the following outcomes.
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. On the other hand, when quantitative tightening takes place, the funds that were created are destroyed. This reduces the amount of money in circulation.
Banks generally have more funds to lend when there is more money in the economy – which can drive down interest rates. On the other hand, a reduced money supply lowers the amount of funds available for banks to lend – which can push market interest rates higher.
Higher Loan Payments
As interest 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. Even if businesses do qualify, they may find it difficult to afford the payments. Therefore, higher interest rates can make some projects unfeasible that otherwise would have moved forward.
Higher Investment Returns
While it is easy to focus on the negative ramifications of rising interest rates, there are positive outcomes as well. One of these is that the rate of return that businesses earn on their cash investments often increases with interest rates.
As quantitative tightening pushes interest rates higher, businesses could expect to earn more on bond investments. Since market interest rates are often aligned, higher yields on bonds can spill over into other areas – like deposit rates. This could mean that business cash reserves earn more during quantitative tightening, 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, an increased risk premium could mean that they must pay higher yields on the bonds they issue. This added expense can increase the cost of issuing bonds.
How Businesses Can Respond to the Effects of Quantitative Tightening
The purpose of quantitative tightening is often at odds with a business’ goals of expansion and profitability. However, there are ways that businesses can respond to – and even profit from – the higher interest rates often associated with quantitative tightening.
Cash Over Credit
In any economic environment, businesses have a choice between funding their expansionary activities with cash or credit. When interest rates are high, many businesses choose to fund their most pressing needs with cash.
Protect Cash Reserves
Quantitative tightening and the higher interest rates that accompany it can dampen the economy. In turn, this can lead to turmoil in the banking sector – as evidenced by the bank failures in 2023. Businesses can respond to this risk by ensuring their cash reserves are covered by FDIC or NCUA insurance. These government programs are backed by the full faith and credit of the U.S. government, making them the ultimate protection against bank failure.
Both FDIC and NCUA coverage are limited to $250,000 per ownership category at each insured financial institution. However, advances in financial technology – a.k.a. fintech – have made it possible for companies to secure protection for unlimited sums.
Seek Higher Investment Returns
When cash reserves aren’t being used to fund projects, they need to be earning a competitive return. In the past, CFOs have spent tremendous amounts of time researching deposit rates and maintaining relationships with multiple banks to ensure they receive competitive rates for their cash reserves. With advances in fintech, businesses can now receive nationally competitive rates without the hassle.
Earn More, Risk Less® with ADM
Our company, the American Deposit Management Co. [ADM] has developed proprietary fintech which allows us to spread business cash across a nationwide network of financial institutions that compete for deposits. This provides our clients with access to unlimited FDIC / NCUA insurance and nationally competitive returns. We accomplish all of this with one account and one consolidated monthly statement.
If cash reserves are growing at your company, or if you are looking to gain an advantage on the competition in a high interest rate environment, contact us today.