Global Economics
|
15th February 2022
GLOBAL ECONOMICS UPDATE
What to expect from QT
•
Quantitative tightening (QT), namely the shrinking of central banks’ balance sheets, is likely to play an
active role alongside rising interest rates in the tightening of monetary policy over the coming months.
However, central banks will have to play it by ear when it comes to the mix of these policies. If QT sparks
a bigger tightening of financial conditions than expected, then interest rates may not have to rise by much.
•
The unconventional policy measures undertaken during the pandemic have taken central banks’ balance
sheets to new highs. (See Chart 1.) Some of the rise has reflected temporary liquidity assistance to ease
strains in financial markets, much of which has already reversed as these short-term measures expired. But
most reflects longer-lasting policies related to monetary policy objectives. (See Chart 3 in here.)
•
This balance sheet expansion is only just coming to an end. The Bank of Canada finished buying new
assets in October, and the Bank of England did so in December. The RBA is due to stop this month, the US
Fed in March and the ECB at the end of this year (though we think this will be brought forward). But already
a reversal of this expansion is on the horizon in many of these countries. (See Chart 2 for the US and UK.)
While there are good reasons for central banks to keep their balance sheets bigger than they were before
the financial crisis (see here), they will want ultimately to reverse a good part of the increase.
•
The US Fed was the only central bank to undertake QT after the global financial crisis, and it did so
extremely slowly. It did not start until October 2017, almost two years after the first interest rate rise, once
rates had reached 1% to 1.25%. And caps on the run-down were set very low; initially at only $10bn per
month, before rising to $50bn per month (equivalent to only 1.2% of the balance sheet then).
•
However, there are reasons for the US Fed – and other central banks – to move more quickly now. (See
here.) Financial conditions are even looser now, and the US Fed in particular faces an unusually flat yield
curve for the start of a tightening cycle. (See here.) Inflation is higher. Central bank balance sheets are much
bigger. And in the case of the US, the Fed has a new standing repo facility which should help to avoid a
recurrence of the bout of volatility in markets seen during the QT of 2019.
•
Most central banks want to wait until they have begun to raise interest rates before starting QT. The
exception is the Riksbank, where we think that balance sheet reduction will take precedence over rate
hikes, given the substantial stock of mortgage-backed covered bonds that the central bank has acquired
over the past year. (See here.) There are various reasons for prioritising rate rises over QT. Interest rates
are quicker and simpler to control. They have a more reliable relationship with inflation. And central banks
seem to view creating headroom to cut rates again more important than creating headroom to expand QE.
•
But in most cases, the gap between raising rates and starting QT will not be long. As it happens, we don’t
think that central banks need to be in a rush to reduce the size of their balance sheets. (See here.)
Nonetheless, the Bank of England this month said that it would start its run-off now that Bank Rate has
reached 0.5%. The Bank of Canada has said it expects to start QT when its raises interest rates or soon after.
And while the US Fed has not yet issued a timetable, it has given a strong indication that the period of time
between stopping purchases and shrinking the balance sheet will be short. (Continued overleaf.)
Chart 1: Central Banks’ Assets/Liabilities as a % of GDP
140
Japan (LHS)
US Fed (RHS)
Bank of England (RHS)
ECB (RHS)
120
100
Chart 2: Central Banks’ Assets/Liabilities
70
10,000
60
9,000
50
8,000
60
30
40
20
3,000
10
2,000
0
2008
Source: Refinitiv
2010
2012
2014
2016
2018
2020
2022
5,000
1,000
600
4,000
400
200
1,000
0
1,200
800
6,000
40
0
2006
UK (RHS, £bn)
7,000
80
20
US (LHS, $bn)
09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
0
Sources: Refinitiv, Capital Economics
Vicky Redwood, Senior Economic Adviser, +44 (0)20 7808 4989, victoria.redwood@capitaleconomics.com
Global Economics Update
Page 1
Global Economics
•
The ECB will be more cautious than other DM central banks about shrinking its balance sheet because of
the risk of triggering an increase in the spread between core and peripheral bonds. Indeed, it has said that
it does not intend to shrink its PEP portfolio until the end of 2024 and that it will maintain its APP portfolio
“for an extended period of time past the date when it starts raising the key ECB interest rates”.
•
Initially, central banks will undertake QT by no longer fully reinvesting the proceeds from maturing assets.
This has the benefit of providing a predictable and gradual path for the reduction in the stock and is
operationally straightforward. Some central banks have large amounts of assets with a relatively short
maturity and so are likely to introduce a cap on the run-down. (See Chart 3.) This includes the Fed, which
has bought a large amount of short-term Treasuries and which we expect to issue a cap that quickly rises
to $100bn per month before the end of the year. (See here.) The Bank of Canada is likely to introduce a
cap too, in part due to the bumpy profile of its maturing assets. (See here.)
•
If this process goes smoothly, then central banks may decide to accelerate the process by actively selling
assets. This is especially the case for the UK and Australia where the average maturity of the assets held is
quite long. Indeed, the Bank of England has said that it will consider actively selling assets once Bank Rate
reaches 1% (which we expect to happen in August.)
•
There are worries about the losses that QT might generate for central banks if it sparks a big rise in bond
yields. Given the scale of assets that central banks hold, it would not take much of a loss to wipe out their
equity. The simple measure of central banks’ equity on their balance sheets equates to only around 1% of
the total value of their assets. (See Chart 4.) However, we have pointed out before that losses do not matter
for central banks in the same way they do for companies. (See here.) After all, various central banks,
including Chile, the Czech Republic, Israel and Mexico, have pursued their policy aims effectively in spite
of technical insolvency in recent years. And if needs be, governments could recapitalise central banks.
•
It is unlikely that QT will have a big direct impact on the real economy given that – as far as we can tell
– QE itself did not have a particularly big effect. Although in theory QE could have led to a surge in bank
lending and broad money, this never materialised. So there is little risk of a big monetary contraction now.
And it seems unlikely that QT will put a big dent in sentiment.
•
The main impact of QT is therefore likely to be on financial markets, where QE itself probably had at
least some impact. It is possible that QT strengthens expectations of future rate rises. Yet rate rises are
already widely anticipated; in fact, if markets view QT as a substitute for rate hikes, it could prompt rate
expectations to fall. QT’s main impact will probably be to contribute to a rise in the term premium. (See
here.) That said, we are not anticipating a “taper tantrum” style spike in bond yields. Even if this did happen,
central banks would probably just pause QT or even resume QE.
•
If QT generates some tightening of financial conditions over and above that which would be achieved by
raising policy rates alone, then it probably makes sense to think of QT as substituting for rate rises to at
least some degree. Indeed, some Fed officials have talked about more adjustment to the balance sheet
allowing a flatter funds-rate path. If central banks succeed in their aim of undertaking QT in a controlled
way, then the impact on the path of interest rates will probably be fairly marginal – although there are still
good reasons for them to peak at a relatively low level compared to past cycles. (See our forthcoming
Global Economics Focus.) But if QT were to generate an unexpectedly big tightening of financial
conditions, then interest rates would presumably peak at a significantly lower level than otherwise.
Chart 3: % of Central Bank Holdings of Government
Bonds By Maturity Date
25
25
2022
2023
20
15
15
10
10
5
5
0
0
UK
Canada
Sources: Central banks, Capital Economics
Global Economics Update
1.4
1.4
1.2
1.2
1.0
1.0
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
2024
20
US
Chart 4: Central Banks’ Equity As a % of Assets
Australia
0.0
Japan
UK
US
EZ
0.0
Sources: Central banks, Capital Economics
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Global Economics
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