Central banks have been credited with preventing global depression twice in the past 15 years, once after the 2008 financial crisis and again at the height of the coronavirus pandemic.
But the tactics they used to restore confidence and keep money flowing from banks to the economy were an egalitarian experiment that could not be undone without destabilizing the financial system.
Central banks have bought tens of trillions of dollars in government bonds and other assets in an effort to lower longer-term borrowing costs and stimulate their economies. The measure, known as “quantitative easing” or QE, created a flow of cheap cash and gave policymakers new leverage over markets. Investors called it the era of “easy money.”
But as inflation hit its highest level in a generation last year, central banks have gone to unprecedented lengths to shrink their bloated balance sheets by selling securities or letting them mature and disappear from their books. According to a recent analysis by Fitch Ratings, “quantitative tightening” or QT by leading central banks will drain $2 trillion of liquidity from the financial system over the next two years.
A liquidity drain of that magnitude could intensify pressure on the banking system and markets, which are already facing a sharp rise in interest rates and active investors.
“There are concerns that we are in uncharted territory,” said Raghuram Rajan, a former Reserve Bank of India governor who presented a paper on these risks last year at a gathering of central bankers in Jackson Hole, Wyoming. He noted that “unintended consequences” are likely as QT continues.
Purchases of long-term government bonds and assets such as mortgage-backed securities in 2009-2022 By the US Federal Reserve, the Bank of England, the European Central Bank and the Bank of Japan, the total was $19.7 trillion, according to Fitch.
Now, the world’s most powerful central banks, apart from the Bank of Japan, are steadily shrinking their balance sheets, and no one knows exactly what will happen as more and more liquidity is drained from the financial system.
In 2017, Janet Yellen compared QT to “watching paint dry”, describing the process as “something that goes quietly in the background”. Rajan, now a finance professor at the University of Chicago, disagrees. He noted that investors and banks measure their strategies by the amount of money available in the financial system.
“The problem is that demand for liquidity is growing and it’s very difficult to wean the system off of it,” Rajan told CNN, likening QE to “addiction.”
The Fed’s direct indication that it intended to reduce the pace of its asset purchases in 2013 led to so-called “concrete rage,” with investors dumping US government bonds and stocks.
And when the central bank tried QT by shrinking the size of its balance sheet between 2017 and 2019, some markets soon became nervous. In September 2019, for example, the U.S. overnight lending market, which banks use to make quick and cheap loans for short periods, unexpectedly seized. The Fed had to step in with an emergency injection of liquidity.
After all, “there’s a lot of uncertainty” as the era of “very easy money” ends and a new chapter begins, according to Gary Richardson, an economics professor at the University of California, Irvine.
According to some experts, the destabilizing effect of QT is evident in two episodes of acute market stress in the past eight months.
The sharp sell-off in UK government bonds last September, which sent the pound crashing down and prompted the Bank of England to intervene repeatedly, was partly driven by former prime minister Liz Truss’ fears of increasing government borrowing just as the Bank of England was preparing to launch a government bailout. sale of debt. Investors expected that the excess of gilts would reduce their value.
The crisis “demonstrated the risk of disruptive dynamics” in government bond markets during QT and should serve as a “wake-up call,” Fitch analysts said in their report.
QT also contributes to turmoil in the US banking sector by exposing weaker players such as Silicon Valley Bank, which failed in March, Rajan said. Banks saw deposit bubbles in the era of easy money, accumulating liabilities in excess of the amount insured by the federal government. Then central banks began withdrawing liquidity from the financial system. That creates a dangerous mismatch if depositors suddenly demand their money.
Even worse, many banks have large holes in their balance sheets because central banks have raised interest rates at the same time. Higher interest rates have eroded the value of much of the banks’ investments, including long-term government bonds that were once considered safe.
“My advice has always been: “Don’t do a QT before you get your interest rates in order,” Rajan said. “Doing both at the same time makes things much more complicated and can cause problems.”
Central bankers say they are taking a gradual and predictable approach to QT to minimize disruption.
“What we’ve tried to do is put markers on the road map,” Dave Ramsden, the Bank of England’s deputy governor for markets and banking, told the UK parliament on Thursday.
In a note to clients this week, Jennifer McCone, chief global economist at Capital Economics, noted that bond markets appear to have been more sensitive to rate hikes than QT over the past year. QT’s impact so far, he wrote, has been “modest.”
However, markets remain fragile. In its financial stability report last month, the International Monetary Fund said QT in the euro zone, US and UK had reduced liquidity in government bond markets, making them vulnerable to unusually large price swings.
The September crisis in the UK also showed that investors are not the only ones exposed to QT risks. Politicians must also consider a paradigm shift.
Although the level of public debt has risen sharply in recent years, the cost of servicing that debt has been reduced by central banks’ willingness to buy much of it. Governments now have to find other buyers if they want to finance green investment projects or measures to digitize their economies.
Richardson of the University of California, Irvine, believes the central bankers’ new approach could become a major source of divisiveness in the US, even if the fight over the nation’s debt ceiling is resolved.
“If our central bank is no longer going to buy 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 policy.”