Question

Suppose you travel in a time machine to mid-2022 and you discover that the US economy has recovered from the COVID-19 pandemic, the US debt has reached $25 Trillion and that the Federal Reserve's balance sheet, thanks to 2020's quantitative easing has swelled to $7 Trillion. The economy has normalized and Trump's new Fed Chair is Judy Shelton. Further suppose that interest rates have normalized the economic growth is moderate and sustainable, and the CPI hovers around 2%. And, the US budget appears to be approximately balanced (i.e. a very small surplus or deficit) for the first time in many many years.

Considering stable and favorable economic conditions, the Federal Reserve appears poised to unwind their balance sheet with a goal of reducing it to $3 Trillion over a period of 24 months. Let us call this policy action "quantitative unwinding"

QUESTION: Ceterus paribus, what effect would the "quantitative unwinding" have on interest rates in the economy for from mid-2022 to mid-2024. Please support your answer with reasoning based on the principles of bond supply and demand and/or the loanable funds framework.

Answer 1

The above case talks about a situation where the current US economy is expected to have been recovered by mid 2022 and the economic and budgetary systems have been stabilised. In this juncture, the Federal Reserve has decided to unwind the balance sheet, following the policy of quantitative unwinding. Quantitative easing refers to a process of introducing new money in to the system whereas unwinding the balance sheet and introduction of quantitative unwinding process means that the securities that mature are not replaced in the market and further steps are taken so as to reduce the Federal Reserve’s balance sheet.

                                    This unwinding of Quantitative easing and tightening of the monetary policy will have a broad impact on the US market by 2024. The loanable funds model uses the supply and demand to illustrate the determination of interest rate decided on the interaction between the savers who supply money and the investor who borrows money. The following are expected to be the results of this unwinding policy on the market considering the loanable funds framework in to account.

· The supply of government bonds starts to disappear.

· Quantitative Easing has the effect of reducing the term premium on long term bonds and thus by unwinding this policy, these yields could increase.

· The market rates are expected to rise.

· It would lead to increase in the price volatility of the bond market from which many trading firms are expected to benefit.

· Inter-dealer brokers, clearing houses etc are expected to make benefit out of increasing bond trading volumes.

· The excess reserves of the commercial banks would fall and the Federal reserve would have less asset holdings.   

                                        The above facts represents that unwinding the balance sheet [quantitative unwinding] would lead to a tightening monetary policy which would mean a hike in the market rates and a fall in the excess reserves of the banks.