In 2018, the Federal Reserve initiated quantitative tightening (QT) to reduce its post-GFC bloated 4.4e12 USD balance sheet. The economy slowed down and the Fed aborted QT in mid-2019, having shaved the balance sheet down to 3.8e12 USD. Then pandemic struck, and the Fed swung into economic support mode.

Post-pandemic, the Fed's balance sheet is now 7.6e12 USD and a return to 1.5e12 normalcy would require more than ten times 2018's failed QT (ie. 10 years of QT at the 2018 run-off rate).

Can't the Fed just ignore the balance sheet?

A near-term unavoidable yet elucidatory problem is the economy's transition from pandemic to post-pandemic. The epically huge balance sheet was purchased by issuing reserves to banks, which means banks have the reserves available to triple the amount of loans extant if they so desire. While post-pandemic lending to rebuild may be slow, it seems at least plausible that there might be a large amount of lending and immediate spending as businesses re-gear (good luck directing banks to not help their communities rebuild).

The more reserves banks have, the larger a possible spike in spending, and the less likely price stability will be preserved. And to top it off, banker conservatism is naturally wary of the Fed's lack of experience operating with a large-scale balance sheet (imagine being stuck with a balance sheet that only ratchets up because QT cannot burn fast enough to avoid interruption by the next economic shock).

A Return to Normalcy

While the economic slowdown in 2019 may have been just coincidental, the Fed is now warning everyone that they will let inflation rise higher than the 2 pct pa. they have previously targeted. Barring unexpected difficulties, this sets the stage for an economic expansion if not a post-pandemic euphoria.

Theoretically, keeping rates low and letting the economy run hot will lead people to increase borrowing; the Fed will then offset the growth in lending and concomitant increase in the money supply with QT as needed. Ideally, the QT burn can run at a higher rate than 2018 and help avoid a redux of 2020, ie. being forced to ratchet up the balance sheet again.

The Treasury

The big monkey wrench in this plan is the Treasury and its need to finance the ongoing federal deficit by selling Treasuries, ie. it has to sell the same goods that QT will be selling.

The Fed has historically let Treasury drive, which means that the forced selling by the Treasury may crowd out QT asset run-off. To help avoid that, the economy must then run hotter than it did in 2018.

Saturday Night Special 2

With an economy that has grown accustomed to growth and an acquiescent Fed, we may end up having to raise rates back to 2000 or 1979.

The big problem is that we do not fully understand inflation expectations. We may end up in a situation like the early 1980's with several years of fighting down inflation.

So those options seem to be the range of outcomes: a) QT burn is interrupted by another economic shock, b) QT burn works fine, inflation subdued, or c) inflation expectations unleashed, cue the Volcker script.

Since option A leads into an escalating trap and option C leads to the known but difficult, it seems likely the Fed will lean towards over-heating the economy. Which is what they have indirectly been telling us.

Damn the torpedoes. Full Speed Ahead!
-- Rear Admiral David Farragut