The Federal Reserve or the Fed plays a critical role in stabilizing the economy of the United States. Adjusting the Federal Funds rate is the prime tool used by this Central Bank to influence economic activity. As Kavan Choksi Professional Investor says, the Fed may increase short-term interest rates to battle high inflation or lower it to incentivize investment. It may also impact long-term rates, which tends to be carried out by purchasing or selling government securities and other financial instruments. This approach is referred to as quantitative easing (QE) or tightening (QT).
Kavan Choksi Professional Investor briefly talks about the Fed’s quantitative easing and tightening measures
In the most basic sense, quantitative easing and tightening are opposite actions. The former implies to the purchase of assets by the Fed to lower longer-term interest rates. On the other hand, quantitative tightening means that the Fed is selling assets to put upward pressure on longer-term rates.
Quantitative easing is generally used to reduce interest rates on longer-term securities and stimulate the economy. The Fed tends to achieve this goal by buying large quantities of mortgage-backed and Treasury securities. As such purchases can lower longer-term interest rates and elevate liquidity in financial markets, it aids in providing economic stimulus. The Fed has historically used QE measures when short-term interest rates were close to zero and additional monetary stimulus was required, like during a financial crisis or recession. The Fed, for instance, employed QE during the COVID-19 pandemic and grew its securities portfolio from under $4.0 trillion in March 2020 to $8.5 trillion by the March of 2022.
On the other hand, quantitative tightening is used to cool the economy by enabling assets to mature off the central bank’s balance sheet or by selling them off. Diminishing the Federal Reserve’s portfolio of longer-term debt can lead to higher longer-term interest rates. This essentially results in reduced consumer spending and domestic spending. In an effort to tame inflation and restrain economic activity, the Fed started to implement QT in the middle of 2022.
As per Kavan Choksi Professional Investor says, quantitative easing helps boost the economy by lowering the cost of capital and encouraging additional business investment with the reduction of long-term interest rates. Lower cost of credit also supports higher domestic consumption. Such changes in the economy can impact federal revenue and spending. For instance, during economic downturns outlays for programs considered to be automatic stabilizers, like Medicaid and unemployment insurance, tend to go up as more people become eligible for federal support. However, as quantitative easing aids in stimulating the economy and mitigating economic downturns, outlays like these could be lower than they would be without QE. Additionally, increased economic activity also implies to increased tax revenues for the federal government. Quantitative tightening has a very different effect. After all, higher interest rates can slow economic growth, ultimately lowering revenues and increasing outlays.
The primary channel through which quantitative easing affects net borrowing costs is via a reduction in market interest rates. In case the Federal Reserve pushes rates up through the use of QT or pushes rates down through the implementation of QE, these actions would impact interest paid on new borrowing, and hence influence net interest totals in the Federal budget.
