In the wake of the global financial crisis of 2007-09, investors and politicians got used to the idea of quantitative easing (QE), a new twist on monetary policy. QE was adopted because cuts in interest rates to their floor near zero were insufficient to counter the deflationary and contractionary forces brought about by the crisis. Central banks used QE to expand their balance-sheets, creating money (in the form of bank reserves) to buy government bonds and other assets from the private sector. The aim was to reduce the cost of borrowing money over the long term, particularly in the bond market. But recently central bankers have begun to reach for a different monetary-policy lever: quantitative tightening (QT). The European Central Bank started the process in March 2023. What does it involve?
QT reverses QE, contracting rather than expanding a central bank’s balance-sheet. It can be done in two ways. So-called passive tightening involves the central bank holding bonds it bought until maturity, and then not reinvesting the proceeds. Active tightening means selling the bonds in the secondary market. In both cases the private sector must then hold more government bonds and so in theory has less appetite to lend money elsewhere. As the central bank sells bonds, its balance-sheet shrinks.
Central banks have been cautious about the extent and pace of QT. If QE drove down bond yields, it is logical to expect QT to push yields higher. In 2013, when the Fed proposed merely to reduce the pace of bond purchases, the market suffered a “taper tantrum” during which yields rose rapidly (though some argue this is because the market’s expectations of traditional interest-rate rises were brought forward by the announcement). The Fed commenced QT in 2017 but then paused the policy in 2019, with its balance-sheet (at around $4bn) still well above pre-crisis levels. The pandemic required even greater monetary expansion and QT only began again in June 2022.
It is hard to assess the impact of QT so far since central banks have been much more vigorous in tightening monetary policy by the more traditional route of pushing up short-term interest rates. They have been responding to the surge in inflation that followed Russia’s invasion of Ukraine in February 2022, which led to sharp increases in the cost of energy. Bond yields also tend to increase when inflation rises.
By comparison with the effect of higher inflation and short-term rate increases, the effect of QT on bond yields has probably been minimal. But central banks will be cautious about the risk that QT will lead to excessive monetary strictness, and thus economic damage. As a result, it is likely to be a long time before QT shrinks central bank balance-sheets back to anywhere near pre-crisis levels.■
