Quantitative tightening (QT) is the exact opposite of quantitative easing(QE); it’s the process used by central banks to decrease the money supply either by selling the assets they previously purchased or deciding against reinvesting the principal sum of maturing securities. We are more experienced with QE, which was introduced extensively in the aftermath of the global financial crisis to increase the supply of money and stimulate economic growth. Consequently, bond prices rose due to the demand created by the amount of money injected into the system, lowering bond yields and interest rates. In diametric contrast, the goal of the less familiar QT is to normalise (i.e. raise) interest rates to cool inflation by increasing the cost of money and, therefore, reducing consumer spending and investment in the economy.
Unlike QE before it, QT has never been successfully deployed on the scale that seems threatened or promised today to address global economic pressures. Its long-term consequences are unclear, but some risks appear evident.
When QT is introduced, the economy becomes more leveraged, and a rising cost of credit can trigger an economic crisis. Today, governments run on deficits, the housing market is held up by mortgages and large amounts of consumer spending are made on borrowed money with low-interest rates, with credit replacing savings. If QT drives a credit growth weakening with rising interest rates, demand decreases and economic growth weakens.
QT may also cause asset prices to decrease, causing a negative wealth effect. The decrease in aggregate demand will increase demand deficient unemployment due to reduced output. These factors will lead to decreased welfare with a variety of social consequences.
Equity prices are likely to fall as less risky government bonds deliver relatively more attractive yields, impacting equity investors and corporate confidence and capacity for further investment with various additional economic consequences.
Some of these risks materialised with central banks’ previous QT attempts, which required swift correction. In 2017 the Federal Reserve, the European Central Bank and the Bank of Japan decided to reverse their monetary policy stance from a decade of QE post the 2008 crash: they stopped cutting interest rates and reduced the rate of reinvestments from the proceeds of maturing government bonds.
The Federal Reserve established a 15-month schedule to achieve a normalised balance sheet and tackle rising inflation. They started by draining $10 billion (of liquidity) a month, increasing it to $50 billion a month. However, after the S&P 500 Index tumbled almost 16% over three weeks in December 2018, the Fed abandoned rate hikes in January and went on to announce the phasing out of QT in March 2019. Other central banks soon followed.
The equity market suffered due to a shift to bond investments with rising yields. Another reason for QT’s failure may have been its simultaneously aggressive pacing and scale; some argued the Fed had shrunk bank reserves too drastically, leaving lenders scrambling for cash.
Despite this sobering experience, the Fed and the BoE have shown interest in attempting QT again to meet their mandate of sustaining low and stable inflation and to address the serious threat of a global economic crisis. Today inflation rates are soaring and economies and citizens are exhausted in a post-pandemic, geopolitically fracturing world with the emerging threat of energy poverty from the Russia Ukraine war. When QT starts, interest rates will rise, increasing the cost of borrowing and the rewards for saving; aggregate demand and inflation will decrease.
The BoE confirmed it will not buy any further government bonds until at least 2023, and it will also sell about £20bn of the corporate bonds it owns. The US Federal Reserve has also indicated it will begin a process of reversing QE.
Deciding not to buy any more bonds will push bond yields up. This is because as the bonds the central bank owns mature over the period between now and 2023, the government will issue new ones to pay the central bank on those due for maturity in the period. Previously, as part of the QE programme, the central banks would also have bought the newly issued bonds, but under QT, they will not. Consequently, the government will, over the next two years, sell more of the bonds it issues on the open market to private investors, which would likely push the interest rate the government has to pay upwards.
The Fed’s balance sheet has almost hit $9 trillion, which, with its sheer size, distorts the bond market and threatens the future shape of the yield curve. QT can be used to shrink the size of the balance sheet: current consensus anticipates that with QT, there will be a $1.2 trillion decline (to $7.8 trillion) in the Fed’s balance sheet by Q4 2025. As this is likely to be done on a much larger scale than the first time, there is a risk of an even larger crash in the bond market, stock market and the economy if appropriate finesse and pacing are not applied.
I conclude that, although its initial introduction in 2017 wasn’t successful, QT could be a useful policy if used at the right scale, pace and time. Intervention is advisable beyond well-timed direct interest rate rises to address soaring inflation, now running at a four-decade high, and threatened social unrest, and it seems likely with pending elections in the world’s leading economy: the US. If implemented intelligently not only should QT decrease inflationary pressures but also give central banks the ability to use expansionary monetary policy if required by a consequent recession. However, the real question is do we trust in the quality and responsibility of our financial institutions and political leadership, of the economists and regulators, to judge QT execution well? Will they deliver without potentially catastrophic impact on bond and equity markets, on families and businesses, on economies and societies, when the world clearly needs confidence in recovery?