While most of the talk about the Federal Reserve in recent weeks has centered around potential interest rate cuts, a commentary released Monday from Wells Fargo economists focused on quantitative tightening (QT), predicting that the Fed will continue its QT policy through the end of the year.

Quantitative tightening, also known as balance sheet normalization, is an economic tool in which the Fed reduces its monetary reserves by either selling Treasury bonds in the secondary market or letting its existing bonds mature. Its main purpose is to curb inflation by reducing the money supply in the economy.

In February, the annual inflation rate for the past 12 months was 2.8%, according to consumer price index (CPI) data released by the U.S. Bureau of Labor Statistics. The Fed’s preferred annual rate of inflation is 2%.

The Federal Reserve’s current QT policy began in June 2022, when the CPI inflation barometer peaked at 9.1% — the largest year-over-year increase in 40 years. Since then, the Fed has shrunk its security holdings by more than $2 trillion, according to Wells Fargo.

The Wells Fargo economists believe that the Fed will keep tightening at its current pace until the end of 2025 and then stop, with the Fed balance sheet then remaining flat through the middle of 2026.

In fact, the Fed has already begun slowing its QT policy. At the March meeting of the Federal Open Market Committee (FOMC), the Fed announced that it would start easing the pace of its balance sheet runoff starting April 1. Specifically, Fed Chairman Jerome Powell announced that the monthly cap on Treasury security runoff was reduced from $25 billion to $5 billion.

But not every central banker agreed with Powell’s economic assessment. FOMC member Christopher Waller released a statement following the March meeting, espousing his belief that the Fed should continue its current pace of decline in securities holdings.

“Slowing further or stopping redemptions of securities holdings will be appropriate as we get closer to an ample level of reserves,” Waller stated. “But in my view we are not there yet because reserve balances stand at over $3 trillion and this level is abundant. There is no evidence from money market indicators or my outreach conversations that the banking system is getting close to an ample level of reserves.”

Wells Fargo sees Waller’s views as “a sign that some Committee members have a more ‘hawkish’ view on the balance sheet and would prefer to push runoff a bit faster in the absence of clearer signs of reserve scarcity.”

But the economists also think that Congress will act to increase the federal debt ceiling this year, after which the U.S. Treasury will likely issue new debt to replenish the coffers of the Treasury General Account (TGA). That, in turn, will have the effect of reducing bank reserves, according to Wells Fargo.

“The TGA rebuild, when paired with the ongoing QT, should be enough to push bank reserves below the key $3 trillion mark by year-end,” the Wells Fargo commentary states. “Thus, our expectation is that QT will run at its current pace through the end of this year. Starting in 2026, we expect the Federal Reserve to keep its balance sheet flat through roughly the middle of the year.”

Impact on the mortgage industry

At the Fed meeting in March, Powell announced that while the monthly cap on Treasury security runoff was being reduced, the monthly cap on mortgage-backed security (MBS) runoff was left unchanged at $35 billion.

Wells Fargo thinks that these policy changes will lead to a slow decline in the amount of mortgage holdings the Federal Bank holds as it gradually shifts its portfolio to primarily Treasury securities.

“Returning to a primarily Treasury security portfolio would reduce the support that the central bank lends to the mortgage market,” the Wells Fargo economists commented.

The 30-year mortgage rate is benchmarked to the rate of the 10-year Treasury note and is determined by adding a spread to the 10-year rate. According to Fannie Mae, quantitative tightening has the effect of increasing mortgage rates by driving secondary spreads upward, since private investors who are subject to higher interest rates than the Fed would need to purchase the Fed’s unwanted mortgage-backed securities on the secondary market.

The Wells Fargo economists believe that the Fed’s move to replace mortgage-backed securities with short-duration bonds would drive up the yields of longer-term Treasury notes that correlate to mortgage rates.