7 min read

The Good Side of Quantitative Tightening

The Good Side of Quantitative Tightening
This, too, is money

Sucking reserves out of the system can be healthy and expansionary.

I'm sure many will find this statement surprising and counterintuitive, since the opposite of QT is supposedly easing. Yet, things aren't as simple as they seem to be. In this article, I explain all relevant factors that make quantitative tightening beneficial to the monetary system.

The Swap

Fed's "quantitative" actions essentially swap reserves for Treasuries and vice versa. While the reserves part of the trade has been studied relentlessly for the last twenty years, the collateral mechanics are still vaguely understood.

Nevertheless, collateral has always been at the center of the banking system. From bills of exchange in Bagehot times to mortgage-backed securities and Treasury securities in the XXI century, collateral has always been an instrument that facilitated robust financial intermediation, and so economic growth. There is a lot to unpack about the collateral, but first, let's compare reserves to high-quality collateral securities.

Reserves are the central bank's liquid assets that flow around the interbank system, but cannot get out of it. Depository institutions (DI) use these reserves to settle payments between themselves. In case, when a DI doesn't have enough reserves to pay its short-term obligations at a specific time in a given day, then they can use a credit extended to them by the Fed either for a small fee, or for no fee at all, if a DI posts collateral. Reducing the amount of reserves in the system will lead banks to use intraday overdrafts more often, and most likely to delay payments (in that day) as incoming payments are one of bank's funding sources.[1]

Treasuries, on the other had, and especially the on-the-run (i.e. newly issued) Treasuries, are also a type of liquidity. In fact, they're considered to be securities of the highest-quality in terms of safety and liquidity. That's also why US Treasuries are very money-like and similar to the official US legal tender.

Back in the day, before the 2008 Great Financial Crisis, we used to have a lot of, seemingly good, private liquidity that was not issued by a government institution. Now, all securities that are desirable for secured funding belong to a narrow pool of most prestigious government securities (UST, JGB, Bunds, Glits etc.). Central banks can partially influence the quality of a specific public or private collateral through its collateral frameworks, however, for now, let's focus only on the best of the best in the market - US Treasuries.

Money and Collateral

Money market collateral is very similar to money, which conventionally is understood as bank deposits plus banknotes. Safety, liquidity, HQLA status, just to name a few, are some really important attributes, that both of these asset types possess.

The system that creates and distributes collateral is also very much comparable to the system that creates and distributes the regular money. Commercial banks engage in the maturity transformation business through creation of short-term deposits on the liabilities side and long-term loans on the other side of the balance sheet. In contrast, shadow banks source funding through money markets and also lend with a much longer investment horizon. The more collateral they have, the larger their balance sheets can grow.

A textbook explanation of how banks facilitate credit expansion is the money multiplier, which represents how much credit can the banking system create by adding one unit of monetary base. Central bank money is not the only kind of money that can be multiplied, though. Thanks to its repledgability, collateral has its own multiplier, too!

Collateral can "pledged to reuse", which means that the collateral taker can use that collateral in his own name. For instance, he can use obtained collateral as a security to get secured financing on his own[2]. The same repledged security, then can be reused again and again, which in effect creates "collateral-chains". Most academics and regulators regard rehypothecation as a dangerous practice that, by increasing leverage, is a threat to financial stability. Yet, it can't be denied that putting limits on collateral credit creation blocks the oil that lubricates the financial plumbing network. In other words, a lower reuse rate (multiplier) of market-acceptable collateral stifles the growth of money supply.

According to calculations of Manmohan Singh, in years 2007-2018, the reuse rate[3] of collateral declined from 3.0 to 2.2. Moreover, as of March 2022, the Fed keeps on its balance sheet ~$5.7 trillion of US Treasury securities.

Source: Collateral velocity is rebounding

A drop in the reuse rate and at the same time a massive withdrawal of UST from the market doesn't sound very expansionary if those same USTs and their shadow clones are used to back transactions and settle accounts.

Scarcity channel of quantitative easing

If you've been following some academic literature on quantitative easing, you know that there are many theoretical QE transmission channels that were studied by academia and central bankers. Those transmission channels are basically ways of how QE affects markets and the real economy.

Portfolio rebalancing channel, signaling channel, bank lending channel... I could probably name three or four more, but that's not the point. The essence is that practically of paths that show QE in positive spotlight (convincing that it is expansionary) have been extensively studied. However, there is not much research that focuses on negatives. Almost no one is interested in the collateral implications of QE.

It comes out that there is in fact a QE channel that focuses just on that - sucking collateral out of the market. It is called the scarcity channel (or scarcity effect) of QE.

There are only two papers that study this effect (excluding my novice research that hasn't been published yet).

The first one regresses UST special repo rates on supply and demand factors of underlying securities. Findings? Economically and statistically significant. Coefficients imply that a 1% purchase of the total outstanding par value would decrease the SC repo rate by 0.2-0.3 bps.

The second study looks at the Euro area, and the results are roughly the same. Both PSPP purchases and excess liquidity have a negative correlation with a change in SC repo rate. The magnitude differs depending on security and regression specification, but the conclusion is clear. Large-scale purchases of high-quality liquid securities pushes repo rates of these securities down, which is an effect of a higher central bank inflicted collateral scarcity.

PSPP (The European version of QE) caused repo rates to plummet 30 bps below the deposit facility! Source: Arrata et al. (2019)

Advantages of collateral over central bank reserves

Collateral is important, but still central banks, together with regulators, have decided to limit the expansion of its supply in exchange for an additional supply of central bank money, the reserves. The question then arises, is this trade effective in a sense of optimization of resource allocation in the economy. While a rapid reserves growth does have its own merits, there are reasons to believe that the costs of collateral destruction may be in fact greater than the benefits of having excessive reserves.

There are three of those that come to my mind.

The first advantage is the return-on-asset superiority. Most safe and liquid collateral securities yield much more than reserves. As of late March 2022, a 3-month Treasury bill yields over 13 basis points more than the interest on reserve balances. IORB serves to eliminate opportunity cost of holding reserves (making reserves more attractive to hold versus other money substitutes). Therefore, most T-bill rates are significantly higher than the IORB.[4]

The second advantage of collateral is the scope of its flows. As mentioned above, reserves move only in the interbank market, whereas collateral reaches every corner of the monetary system. From hedge funds and asset managers to dealer banks to the Fed to money market funds..., it just gets everywhere, so the chances are that any sudden shock to collateral-based liquidity can be much more quickly resolved than a shock to reserve liquidity.

The third argument that shows how collateral securities trump central bank securities, which partly comes from the two previous ones, is that collateral securities are much more productive, economically. The enormous 2020 QE flooded the system with reserves, but the reaction of lending and domestic product was much smaller. The US "velocity of money"[5], calculated as GDP/M2, in years 2020-2022 went from 1.45 to 1.11, whereas the velocity of collateral is well above 2 and rising.

The spike in UST purchases by the Fed most likely contributed to a collateral shortage that was present in the first half of 2021.

Expansionary QT

Quantitative tightening, by releasing a huge chunk of high-quality market collateral, ironically, appears to be an expansionary policy that adds to the total supply of money. However, the final verdict of whether central bank balance sheet normalization is beneficial to the economy must be weighted by disadvantages of reduced reserves and plethora of a low-yielding collateral in the current regulatory framework. More on that in the next QT post!

For references and further readings, please go here.


Footnotes:

[1]: More on daylight overdrafts in the next QT article.

[2]: Such reuse of collateral is also called "rehypothecation".

[3]: Singh calculates the reuse ratio as a ratio of total pledged collateral  that can be reused on balance sheets of the biggest banks to the source collateral.

[4]: In fact, the opposite case, where most of the short rates are lower than the interest rate on reserve deposits also shows the preeminence of collateral (e.g. in the case of the ECB and short-end German bunds), because it shows that for some reason institutions value that collateral more than reserves (their bidding pulls the yields down).

[5]: Here, I put the phrase in scarce quotes because velocity of money is a theoretical concept that is not observable and M2 is not an accurate aggregate of the money supply.