Before getting into the policy known as quantitative tightening, it's crucial to understand its counterpart: quantitative easing. And since the onset of the global financial crisis in 2007, the major international central banks—the U.S. Federal Reserve, the Bank of Japan and the European Central Bank, and to a lesser degree the Bank of England—have embarked on this monetary policy called "quantitative easing." Also known as QE, the policy sets out to spur economic growth and lower interest rates in their respective domains.
Put simply, the central banks have created money by purchasing financial assets, generally bonds issued by their respective sovereign governments. They also purchase bonds and sometimes, in the case of the BOJ, equity issued by private corporations, in order to make money more widely available to borrowers.
According to a report from Yardeni Research Inc. dated 7 February 2018, entitled "Global Economic Briefing: Central Bank Balance Sheets," the collective balance sheets of the Fed, the ECB and the BOJ have more than quadrupled over the past 10 years, from a little more than US$3 trillion in early 2007 to US$14.6 trillion in January 2018. The following reflect the banks' respective balance sheet growth:
- The Fed's balance sheet has jumped from about US$800 billion before the crisis to more than US$4.4 trillion as of February 2018.
- The ECB's has grown to more than US$5.5 trillion from about US$1.5 trillion.
- The BOJ's has increased to US$4.8 trillion from about US$1 trillion.
As a percentage of local currency GDP, the BOJ's balance sheet has grown the largest by far, accounting for nearly 93% of Japan's GDP at the end of the third quarter of 2017; in 2007, before the crisis, the comparable figure was about 21%. By comparison, the ECB's balance sheet accounts for about 38% of the eurozone's GDP, up from about 12% 10 years earlier, while the Fed's portfolio equates to 22.4% of U.S. GDP, up from about 6% in 2007.
Why Quantitative Tightening?
As memories of the financial crisis and the resulting Great Recession have faded and the world economy has begun to expand again, pressure has been growing on the central banks to start unwinding those massive portfolios and normalising monetary policy for fear of igniting runaway inflation. That process, which would essentially reverse quantitative easing, has come to be known as quantitative tightening. Much as the initial QE policy was unprecedented, "QT" will also be untried and untested. However, it may have more negative repercussions on the world economy and financial markets than QE.
That's because the net effect of massive central bank asset purchases drove up the price of those assets, both bonds and stocks, which benefited most investors. It stands to reason, then, that doing the reverse—either by selling off assets or, in the case of bonds, allowing them to mature—may have the opposite effect. Namely, it would drive down the price of stocks and bonds, which would unnerve investors and have a negative impact on economic growth just as the world economy is starting to rebound.
Driving down the price of bonds should raise interest rates, other things being equal. As an example, the Fed is the largest holder of U.S. government debt, so if it reduces its purchases, more buyers will be needed to pick up the slack. This is especially the case as U.S. Treasury borrowing is expected to rise sharply over the next several years as government deficits increase. If enough new buyers don't materialize, interest rates will have to rise in order to make them more attractive for investors.
That's why the process is called "tightening," because the central bank is essentially draining money out of the financial system. This creates a scarcity, which then makes it more expensive to borrow money. Interest rates, after all, are the price of money.
How Quantitative Easing And Quantitative Tightening Work
While the common belief is that QE involves central banks "printing money," that's not exactly what happens. Rather, central banks essentially create money by depositing money at private banks and other financial institutions and then buy the government securities it wants from them, with the money remaining in those institutions. The intention, the central banks hope, is that this money will be loaned out to corporations and consumers in order to spur business activity.
In reversing the process, the central bank sells assets back to the financial institutions, thus draining the money the bank keep on deposit. That reduces the amount of money they have to lend, which, again, other things being equal, should raise the cost of money to borrowers, i.e, interest rates.
The Move From Quantitative Easing Into Quantitative Tightening
In the U.S., the Fed ended its asset purchases in 2014 but continued to reinvest interest payments and the proceeds of matured bonds into new securities, leaving the size of its portfolio mostly unchanged. On 14 June 2017, the Fed announced it will begin reducing its portfolio holdings as the U.S. economy has finally shown sustained growth. It will allow US$6 billion of Treasury securities to mature each month without replacing them, increasing the total by another US$6 billion a month until US$30 billion a month is being retired. The Fed will follow a similar process with its holdings of mortgage-backed securities, retiring an additional US$4 billion a month until it reaches a total of US$20 billion a month.
The Fed began the process in November 2017 and allowed several billion dollars of government bonds to mature without reinvesting the proceeds. The Fed reported that its portfolio holdings of Treasury securities declined by US$6 billion in its holdings, the first indication that QT had begun. The institution has not indicated that it has any intention of actually selling securities out of its portfolio, and that appears unlikely. So far, there are only plans to allow the portfolio to run off gradually, over a period of several years, in order to minimise the impact on financial markets.
QT has yet to begin at the other major central banks. In October 2017, the ECB announced that it would reduce its monthly asset purchases by half, to €30 billion, beginning in January 2018, with the purchases scheduled to end in September. However, ECB officials have said the program may be extended beyond that date depending on economic data. The BOJ continues its QE program and has given no indication when it may end.
Quantitative tightening is the reverse process of quantitative easing, the monetary policy adopted by the world's major central banks to reduce interest rates and create money following the world financial crisis. QT involves the draining of that money from the financial system in order to normalise, i.e., raise interest rates in order avoid runaway inflation. Like QE before it, QT has never been done before, especially on such a massive scale. This worries many investors, because the likely effect is that it will raise the cost of borrowing and reduce asset prices.
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Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…