Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Quantitative Tightening Without Breaking Markets
Transcript
- Lucas: We talk a lot about central banks cutting or raising interest rates — that's the headline. But there's a whole other channel running beneath the headlines, and it quietly does a huge amount of tightening without ever touching the overnight rate. Luna: You mean quantitative tightening. The balance-sheet unwind. Lucas: Exactly. Quantitative tightening, or QT — the process by which central banks shrink the bond portfolios they built up during quantitative easing. Since the global financial crisis, central bank balance sheets ballooned. The Fed's went from under a trillion to nearly 9 trillion at its peak in 2022. The Bank of Japan's is still sitting at over 130 percent of GDP. Luna: That is a lot of bonds. How do you unwind that without spooking markets? Lucas: That's the trillion-dollar question. Literally. And the answer is: very carefully, and usually passively. Most central banks do QT by simply letting bonds mature and not reinvesting the proceeds. The bond pays back its principal, the money leaves the central bank's balance sheet, and that cash effectively disappears from the financial system. Luna: So it's like a slow leak. Not a sudden fire sale. Lucas: Right. A slow, preannounced leak. The Fed started QT in 2017 the first time, then did a much bigger version starting in 2022. They set a cap — say 60 billion in Treasuries and 35 billion in mortgage-backed securities per month — and anything above that cap gets reinvested. Below the cap, it just rolls off. Luna: And the cap gives markets predictability. You know exactly how much is coming off each month. Lucas: Exactly. The whole philosophy is 'we don't want to be a surprise.' That's why active asset sales — where the central bank actually goes into the market and sells bonds before maturity — are almost never used. The ECB did some active sales in its early tightening, but it was very limited. The fear is that active selling could cause a taper tantrum — a sudden spike in yields that tightens financial conditions too fast. Luna: Well, and we saw that in 2013 just from the suggestion of tapering QE. So actually doing it would be that much more intense. Lucas: Precisely. So passive QT is the preferred method. But it's not risk-free. One big issue is that QT drains reserves from the banking system. Remember, when the Fed buys a bond, it creates a reserve — a digital dollar that sits in the bank's account at the Fed. When the bond matures and isn't reinvested, that reserve gets extinguished. Luna: Which is why some people call it 'stealth tightening.' It raises the cost of credit without a formal rate hike. Lucas: Right. And it can create scarcity. In September 2019, the repo market — that's the overnight lending market for banks and dealers — suddenly spiked to 10 percent because reserves had become too scarce. The Fed had been doing QT, and they took too much liquidity out. They had to step in and inject reserves again to calm things down. Luna: That was a famous 'oops' moment. So the lesson is: you can drain too far, and then you break something. Lucas: Exactly. So the Fed learned. In its current QT cycle — which is still ongoing as of May 2026 — they've been much more careful. They slowed the pace in 2025 when reserve measures started to approach what they call 'ample' levels. They even signaled they'd stop QT entirely once reserves hit a certain floor. Luna: Is there a magic number for that floor? Like, how much is enough? Lucas: Not a precise number, but they watch the secured overnight financing rate, or SOFR. If SOFR starts to drift above the interest on reserve balances — IOER — that's a sign reserves are getting scarce. In late 2025, that drift started, and the Fed tapered its caps. Luna: So it's like a pressure gauge. You watch the plumbing. Lucas: Exactly. Now compare that to the Bank of Japan. They took a different path. The BOJ's balance sheet is enormous because they've been buying not just government bonds but also ETFs and corporate debt. When they tried to taper their bond purchases in 2024, it triggered a sharp rise in Japanese government bond yields and a sudden strengthening of the yen — the yen went from 150 to the dollar to 130 in a matter of weeks. Luna: That must have been brutal for Japanese exporters. Lucas: It was. And it forced a policy pause. The BOJ actually had to step up purchases again to stabilize the market. So their QT has been much more stop-start. They're dealing with a very different bond market structure — the JGB market is less liquid than Treasuries, and the BOJ owns so much that they've become the market. Luna: So for the BOJ, passive QT isn't really possible because the bonds would roll off, but who's buying them? There's no natural demand. Lucas: Exactly. That's the conundrum of 'balance sheet dominance.' The central bank is so big that its own actions determine the price. So they have to go very slowly. The ECB had a similar issue with its bond holdings in some peripheral countries. They managed it with a 'transmission protection instrument' — basically a backstop to buy bonds if spreads blow out. Luna: So does QT actually tighten the economy? Or is it mostly symbolic? Lucas: It does tighten, but the magnitude is debated. One study from the New York Fed estimated that the 2022-2025 QT was equivalent to about 75 to 100 basis points of rate hikes — meaning the Fed's rate hikes were augmented by that much. But it's not linear: the effect depends on how much slack is in the system. Luna: And there's also the reverse repo facility, right? That was a big buffer. Lucas: Yes, the overnight reverse repurchase facility — or ON RRP. Money market funds park cash there. During the early QT, those funds were drained first, so reserves didn't actually fall until the ON RRP balance got close to zero. That happened around mid-2023. After that, reserves started declining directly. Luna: So the ON RRP acted like a shock absorber. Once it was empty, every dollar of QT hit reserves. Lucas: Exactly. And that's when the pressure started to show. Banks became more cautious about lending, and some short-term rates started to drift up. Which brings us to the current situation. Luna: What's happening right now — May 2026? Lucas: The Fed is still in QT, but at a much reduced pace — about 25 billion per month in Treasuries, and they've stopped letting MBS roll off entirely. The thinking is they want to leave the balance sheet at a level that's still ample in reserves — maybe around 6.5 trillion — enough to avoid a 2019-style event but not so large that they're distorting markets. Luna: So they're aiming for that 'ample reserves' regime they talk about. Not pre-crisis scarcity, not post-crisis abundance — somewhere in the middle. Lucas: Right. The problem is nobody knows exactly where that middle is until you test it. And testing it means you risk overshooting. So the Fed has been deliberately cautious, almost data-dependent. They've even said they might stop QT entirely before reaching that elusive 'neutral' level. Luna: It's interesting: QE was this big heroic tool that saved the economy. But QT feels more like a quiet, anxious cleanup. Lucas: Well put. Central banks love being able to cut rates — it's clean, it's fast, it sends a signal. But shrinking the balance sheet is messy, it takes years, and it can break things in unexpected places. That's why some economists argue they should never have gone so big in the first place. Luna: Or at least they should have a clearer exit plan from the start. Lucas: That's the big debate. Some say they should use a standing repo facility to manage reserves, so they can operate with a much smaller balance sheet. Others say large balance sheets are the new normal. But one thing is clear: QT is not just QE in reverse. It's a different animal with its own risks. Luna: Speaking of things that are useful — if this deep dive into central bank plumbing was helpful to you, the way these episodes stay ad-free is through listener support. People who find value in the show, helping keep it going. You can find that at buy me a coffee dot com slash fexingo. Lucas: Yeah, that's a nice way to put it. We pour a lot into making these nuanced topics clear, and knowing listeners appreciate that makes a difference. So if today was useful, consider it. Luna: Absolutely. And speaking of nuance — the next time the Fed announces a rate decision, watch the balance-sheet statement too. That's where the real action often is. Lucas: Good note to end on. Next episode we'll look at the 'neutral rate of interest' — the mythical r-star — and why central banks keep disagreeing about where it sits. See you then.