Quantitative tightening: what happens when $2 trillion is sucked out of the global economy


In the last 15 years, central banks have managed to prevent a global depression twice: Once after Financial crisis of 2008and up again coronavirus pandemic.

But the tactic they used to restore confidence and keep money flowing from the banks into the economy was a high-stakes experiment – one that may be impossible to unwind without destabilizing the financial system.

Central banks have purchased tens of trillions of dollars worth of government bonds and other assets to lower the long-term cost of borrowing and boost their economies. This measure, called “quantitative easing”, or QE, triggered a flood of cheap cash and gave policy makers newfound power over the markets. Investors called it the “easy money” era.

But because inflation hit her the highest level in one generation last year, central banks embarked on an unprecedented scale to reduce their bloated balance sheets by selling securities or letting them mature and disappear from their books. “Quantitative Tightening” or QT, used by top central banks, will drain $2 trillion of liquidity from the financial system over the next two years, according to last analysis by Fitch Ratings.

A liquidity outflow of this magnitude could add to the tensions in the banking system and markets that are already struggling sharp rise in interest rates and crazy investors.

“There are concerns that we are in uncharted territory,” said Raghuram Rajan, a former governor of the Reserve Bank of India, who presented a paper on these risks at the Jackson Hole, Wyoming, central bankers’ meeting last year. He noted that “unintended consequences” were likely as QT continued.

In 2009-2022, purchases of long-term government bonds and assets such as mortgage-backed securities by the US Federal Reserve, the Bank of England, the European Central Bank and the Bank of Japan, according to Fitch, amounted to a staggering $19.7 trillion.

Currently, the most influential central banks in the world – apart from the Bank of Japan – are systematically reducing the size of their balance sheets, and no one knows for sure what will happen when more and more liquidity is withdrawn from the financial system.

In 2017, Janet Yellen compared QT to “watch paint dry”, describing the process as “something that runs quietly in the background”. Rajan, now a finance professor at the University of Chicago, disagrees. He noted that investors and banks calibrate their strategies to the amount of money in the financial system.

“The problem is that the demand for liquidity is increasing and it’s very difficult to wean the system off of that,” Rajan told CNN, comparing QE to “an addiction.”

The usual signal from the Fed that it intended to slow down the pace of asset purchases in 2013 led to a so-called “tank fit” in which investors shed US government bonds and equities.

And when the central bank tried QT by reducing the size of its balance sheet between 2017 and 2019, trouble soon followed in some markets. For example, in September 2019, the US overnight loan market – used by banks to borrow money quickly and cheaply for short periods – unexpectedly grabbed. The Fed had to intervene by providing a sudden injection of liquidity.

Ultimately, according to Gary Richardson, professor of economics at the University of California, Irvine, “there’s a lot of uncertainty” as the period of “very easy money” ends and a new chapter begins.

According to some experts, the destabilizing effects of QT are evident in two episodes of acute market tensions in the last eight months.

AND sharp sale in UK government bonds or gilts last September – which collapsed the pound and required the intervention of the Bank of England repeatedly — was partly triggered by concerns about former Prime Minister Liz Truss’ plans to increase government lending as the Bank of England was about to launch a government debt sale. Investors predicted that the oversupply of gilts would reduce their value.

The crisis “showed the risk of disorderly dynamics” in QT government bond markets and should serve as a “wake-up call”, Fitch analysts said in their report.

Bank of England building in London

QT is also adding to the turmoil in the US banking sector by exposing weaker players such as Silicon Valley Bank, which collapsed in March, Rajan said. Banks saw an increase in deposits in the era of easy money, piling up liabilities far in excess of the amounts insured by the federal government. Subsequently, central banks began withdrawing liquidity from the financial system. This creates a dangerous mismatch should depositors suddenly demand their money back.

To make matters worse, many banks have big holes in their balance sheets because central banks simultaneously raised interest rates. Higher interest rates have devalued much of the banks’ investments, including long-term government bonds that were once considered safe.

“My advice has always been, ‘Don’t do QT before interest rates are sorted out,'” Rajan said. “Doing both at the same time greatly complicates things and can cause problems.”

Central bankers say they take a gradual and predictable QT approach to minimize disruption.

“What we’ve tried to do is mark the routes on a map,” Dave Ramsden, deputy governor for markets and banking at the Bank of England, testified on Thursday before the British Parliament.

In a note to clients this week, Jennifer McKeown, chief global economist at Capital Economics, noted that bond markets appeared to be more sensitive to interest rate hikes than QT over the past year. She wrote that QT’s impact so far has been “modest”.

However, the markets remain volatile. The International Monetary Fund stated in its financial stability report Last month, the QT in the Eurozone, US and UK reduced liquidity in government bond markets, making them vulnerable to unusually high price volatility.

The September crisis in the UK also showed that not only investors are exposed to QT risk. Politicians should also consider the ongoing paradigm shift.

While the level of public debt has skyrocketed in recent years, the cost of servicing this debt has been lowered by the willingness of central banks to buy large chunks of it. Now governments need to find other buyers if they want to finance green investment projects or efforts to digitize their economies.

Richardson of the University of California, Irvine, believes that the central bankers’ new approach could become a major source of friction in the United States, even if the fight over the country’s debt ceiling is resolved.

“If our central bank no longer buys all these bonds, the interest on the debt will be much higher,” he said. “At some point, what the Fed is going to do is get into politics.”

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