A tale of two tightenings

Abstract

Balance sheet policy is now a prominent facet of monetary policy. Based on the U.S. experience between 2017 and 2019, Smith and Valcarcel (2023) show the first period of quantitative tightening (QT1) was markedly different from earlier balance sheet expansions. This paper provides evidence the Federal Reserve's second balance sheet unwind effort that began in January 2022 (QT2) is strikingly different from QT1. We find substantial announcement effects during QT2 for various treasury yields and interest rate spreads, which are largely absent from QT1. At the time of this writing—by February 2023—both episodes have experienced a similar percent reduction in reserve balances. Yet, QT2 shows a stronger market response upon implementation. Not only are the underlying financial conditions different across the two periods, but the conduct of monetary policy in 2022 seems to be different as well. A clearer signaling mechanism for the expectations channel of monetary transmission takes place during QT2 than was apparent during QT1. The liquidity effects that seemed to be so important during QT1 have been largely attenuated during the second episode of balance sheet tightening.