- The Federal Reserve is currently shrinking its balance sheet through quantitative tightening.
- It's choosing not to reinvest the proceeds from maturing bond holdings in a bid to tame inflation.
The Federal Reserve is making a grave policy error by pressing ahead with efforts to shrink its balance sheet, Mizuho Securities' chief economist has warned.
Steven Ricchiuto said that the Fed's so-called quantitative tightening (QT) — where it shaves off around $95 billion in Treasury bonds and mortgage-backed securities each month from its $9 trillion balance sheet — was an untested program that could badly disrupt market liquidity.
"I believe it is a complete mistake for the Fed to attempt to shrink the size of its balance sheet," he wrote in a research note Monday.
The US central bank is implementing QT alongside outsized interest-rate increases in a bid to tame inflation, which cooled slightly to 7.7% in October.
It's reducing the size of its balance sheet by allowing around $2 trillion of its long-term government bond holdings to "roll off" — meaning it chooses not to reinvest after some of its fixed-income assets mature.
But QT has never been done on this scale before — meaning that economists can't be certain it will work alongside the Fed's rate-hiking campaign to curb soaring prices.
The Fed also warned earlier this month that the $24 trillion Treasury market was experiencing low levels of liquidity, which Ricchiuto said is likely due to it rolling off its bond holdings.
"The historical experience with how the system functions in an ample reserve framework is exceptionally limited and equating QT to rate hikes appears to be the wrong approach," he said.
"This suggests there is a nontrivial probability that market liquidity will be adversely affected well before the targeted $2 trillion has been rolled off, preventing the Fed from accomplishing its goal," Ricchiuto added.
However, the Fed is unlikely to return anytime soon to the quantitative easing (QE) bond-buying spree it pursued between 2008 and 2014 and then after the coronavirus pandemic hammered the US economy in 2020, according to Ricchiuto.
That's because QE is inflationary. The policy requires the Fed to buy up Treasurys in a bid to push down interest rates on savings and loans, which boosts consumer spending and leads to prices rising.
"Quantitative easing is unlikely to be reinitiated given the ongoing struggle with inflation," Ricchiuto said.