Quantitative tightening – not just drying paint

The financial crisis saw major central banks launch quantitative easing (QE) programmes as part of a ‘shock and awe’ policy response, buying up government bonds as interest rates got too low to cut any further.

Quantitative tightening (QT) – reducing that stock of assets (mostly government bonds) – is currently underway in several major economies. Rate hikes, not QT, are being used as the primary policy instrument. In 2017, the Federal Reserve’s (Fed) Harker quipped that QT would be like “watching paint dry”. However, there is still a significant amount of uncertainty around the effects of QT, and its effects could be being significantly underappreciated. As the Bank of England (BoE) approach their annual QT review, it’s worth taking stock…

Central banks not sounding confident; QT effects uncertain:

So far, central banks do not sound confident in their use of QT. Jerome Powell admitted at the onset of this latest episode of QT that “we have a much better sense, frankly, of how rate increases affect financial conditions,” and said “I would just stress how uncertain the effect is of shrinking the balance sheet” in the May 2022 Federal Open Market Committee press conference. However, the BoE’s Dave Ramsden summarised that “the overall impact of QT on gilt yields appears to have been small.”

Substituting for rate hikes or making them more powerful? Probably both

Neither the Fed, European Central Bank (ECB) or the BoE have revealed an intention at this stage to use QT as much of an active policy tool. All seem to want a predictable, transparent pace of reduction in bond holdings that happens in the background of decisions on interest rates. However, there is some acknowledgment at least of a degree of substitutability with rate hikes. The Fed for example, is explicit that their balance sheet decisions “are guided by our maximum employment and price stability goals.” However, part of the aim of central banks in engaging in QT also seems to be to make rate hikes more effective. The ECB’s Isabel Schnabel suggested that asset scarcity (she pointed out that Eurosystem holdings of euro area sovereign bonds amounted to more than a third of the market) – can “delay or even impair, the transmission of monetary policy.” To the extent QT reverses asset scarcity, that could therefore enhance policy transmission.

QT isn’t just QE in reverse

On the face of it, QT is just QE in reverse, with asset purchases reversed by asset sales. To some extent then, the economic effects of QT should be those of QE but with an opposite sign. However, not only is QT not the primary tool of monetary policy (in contrast to QE at the time), but:

• QT is not being implemented as ‘QE in reverse’: The implementation strategies of QE and QT are not mirror images. QT hasn’t been implemented by active asset sales everywhere, but in some places by a ‘run off’ strategy, or ‘passive’ QT, where maturing bonds held by the central bank are not reinvested. Passive QT generally means that the pace is determined by when assets were bought in the first place and at what maturity. With active QT, central banks control the pace, and this can be adapted as conditions change. Active QT may therefore send a stronger signal on the overall monetary policy stance (signalling has been seen as a key channel for the effectiveness of QE).
• The involvement of market participants is also different. Passive QT need not directly involve market participants at all. Active QT ‘auction events’ could create a focal point for investor flows and positioning. Even with the BoE where some active asset sales are taking place, operations have been conducted in much smaller size than was the case with QE. Even measuring the impact of QT is more difficult when the scale is small, especially set against other bond supply events, changing demand from some market participants and with so much generally going on in terms of the economy, politics and markets.
• No ‘shock and awe’: Part of the reason why the initial wave of QE in 2009 seemed so effective in terms of market impact was likely due to the sheer ‘shock and awe’ element of venturing into this then controversial area. Central banks seem to be trying to embrace whatever the opposite is of shock and awe with their QT plans by making them predictable and gradual. QT could, in theory, be used much more actively, in larger size and targeted at specific parts of the yield curve.

Economic context matters: Could this be a channel for a bigger than expected impact?

In a 2022 BoE piece summarising across a range of research, findings include that QE likely works in different ways at different times and through multiple channels. The importance of those channels has “varied as economic circumstances and market conditions have evolved”. With movements in bond yields a clear channel through which bond sales and purchases can affect markets and the wider economy, the fiscal policy backdrop may work to amplify or dampen the impact of QT. Where large-scale net issuance is still taking place in the aftermath of the pandemic (as is the case currently, for example in the UK), the impact of QT seems likely to be amplified. 

QT and bigger picture risks: Damage to central bank independence and fiscal impacts

QE has intertwined central banks and governments together. This period of QT and restrictive monetary policy may not unwind damage done to perceptions of central bank independence. Thanks to QE, central bank balance sheets have become more vulnerable to higher bond yields/lower bond prices via holding large stocks of government bonds as assets. Meanwhile central bank liabilities built over QE, in the form of commercial bank reserves, to the extent these are remunerated at the policy rate, are sensitive to changes in the policy interest rate. In the UK, for example, the BoE is fully indemnified by the Treasury. So, as interest rises that could mean bigger transfers from the government to the Bank.

The Bank of England seems likely to increase the pace of QT somewhat at their September meeting. Deputy Governor, Dave Ramsden, laid out several reasons why in his view a “carefully considered” increase in the pace of reduction of the stock of gilts might make sense, including having more confidence about the economic and market effects. However, he also noted that given the higher maturities over the year from October 2023, the stock of gilts can fall more than over 2022-23 without needing to increase active gilt sales in the market much. Targeting something like a £100 billion reduction in the stock of gilts, compared to £80 billion over the previous year seems a reasonable central case.

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