What is quantitative tightening?
Quantitative stress (QT) is a contractionary monetary policy A tool used by central banks to reduce the level of money supply, liquidity and the general level of economic activity in an economy.
You may ask yourself why a central bank would want to reduce the level of economic activity. They do so reluctantly when the economy overheats, causing inflation, which is the general increase in the prices of goods and services normally purchased in the local economy.
The good and bad side of inflation
Most of the developed countries and their central banks have set a moderate inflation target of around 2% because the gradual increase in the general level of prices is an integral part of stable economic growth. The word “stable” is key because this makes forecasting and future financial planning easier for individuals and businesses.
Inflation and the wage-price spiral
However, hyperinflation can easily get out of control when workers push for higher wages due to high inflation expectations, a cost that companies pass on to consumers through higher prices which reduces the purchasing power of consumers, ultimately leading to further wage adjustments and so on. till then.
Inflation is a very real risk from quantitative easing (QE), a modern monetary policy tool consisting of large-scale asset purchases (usually a mixture of government bonds, corporate bonds, and even stock purchases) used to stimulate the economy in an attempt to recover from a deep recession. Inflation can result from excessive stimulus that may necessitate quantitative tightening to reverse the negative effects (rising inflation) of quantitative easing.
How does quantitative tightening work?
Quantitative tightening is the process by which a central bank sells its accumulated assets (mainly bonds) in order to reduce the money supply circulating in the economy. This is also referred to as “balance sheet normalization” – the process by which a central bank reduces its bloated balance sheet.
Objectives of quantitative tightening:
- Reducing the amount of money in circulation (deflationary)
- Raise borrowing costs along with a higher benchmark interest rate
- Calm an overheated economy without destabilizing financial markets
QT can be made through sales of bonds in the secondary treasury market, and if there is a significant increase in the supply of bonds, the yield or the rate of interest required to entice buyers tends to rise. Higher yields increase borrowing costs and reduce the appetite of companies and individuals who previously borrowed money when lending terms were generous and interest rates were close (or at) zero. Less borrowing results in lower spending, which results in lower economic activity which, in theory, cools asset prices. In addition, the act of selling bonds removes liquidity from the financial system, forcing businesses and households to be more careful with their spending.
Quantitative tightening vs tapering
The term “Tapering” is often associated with the process of quantitative tightening but actually describes the transition period between QE and QT in which asset purchases are broadly reduced or ‘trimmed’ before they come to a complete halt. During quantitative easing, maturing bond yields tend to be reinvested in new bonds, injecting more money into the economy. However, tapering off is the process by which reinvestments are curtailed and eventually stopped.
The term tapering is used to describe additional, smaller asset purchases that are not “tightened” but simply dampen the rate of asset purchases by central banks. For example, you wouldn’t describe taking your foot off the throttle as a break even though the car will start to slow, assuming you’re on a flat road.
Examples of quantitative stress
As QE and QT are fairly recent policy tools, there hasn’t been much opportunity to explore QT. The Bank of Japan (BoJ) was the first central bank to implement quantitative easing but was unable to implement QT due to stubbornly low inflation. 2018 was the only time the US implemented QT only to be discontinued less than a year later in 2019 citing negative market conditions as the reason for its abrupt end. In 2013, the mere mention of Fed Chairman Ben Bernanke’s tapering of the bond market led to a spin, delaying QT until the aforementioned 2018 year. Therefore, the process was largely untested as the program was cut short.
Since 2008, the Federal Reserve has raised $9 trillion on its balance sheet, having cut that number only slightly between 2018 and 2019. Since then, it’s been in one direction.
Fed Assets Buildup Over Time (Peak Close to $9 Trillion)
Source: St. Louis Fed
Possible downsides to quantitative narrowing
Implementing QT involves striking a delicate balance between removing money from the system while not destabilizing the financial markets. Central banks risk removing liquidity too quickly which can frighten the financial markets, leading to erratic movements in the bond or stock market. This is exactly what happened in 2013 when it was Federal Reserve Chairman Ben Bernanke only hinted at the potential to slow future asset purchases resulting in a huge rise in Treasury yields which lowered bond prices in the process.
US Treasury yield weekly chart (orange 2 years, blue 5 years and 10 years)
This event is called a “taper tantrum” and can occur during the QT period. Another drawback of QT is that it is not implemented until it is complete. Quantitative easing was implemented after the global financial crisis in an attempt to ease the deep economic recession that followed. Instead of tightening after Bernanke’s comments, the Fed decided to implement a third round of quantitative easing until recently, in 2018, the Fed started the QT process. Less than a year later, the Fed decided to terminate QT due to the negative market conditions it experienced. Therefore, the only example that should be mentioned is that the future execution of QT could lead to negative market conditions again.