Central banks can tighten by doing nothing
By debating the size of their balance sheets, central banks are showing the first sign since Covid-19 – and only the second time since the 2008 financial crisis – that they might be worried about too loose policy and the growing reliance on quantitative easing.
Following their asset purchases since 2008, the balance sheets of the world’s four major central banks total more than $25 billion (graph 1). This injection of cash into the private sector is equivalent to almost 90% of the gross domestic product of the United States or 115% of that of China. This means that around three-quarters of the world’s central bank‘s $42 trillion in assets have been amassed in just 13 years, after the last (rather than virus-induced) US financial recession ended in mid -2009. QE can be credited with unlocking the system in 2009 and keeping it oiled in 2020. But by prolonging distortions and widening disparities, it seems too flawed a tool to sustain.
Encouragingly, the US, Eurozone and UK have recouped lost nominal GDP since 2019. Yet with recoveries since 2009 largely driven by output and inflation more cost-driven than demand-driven” satisfactory”, central banks cannot adhere to the “old standards”. ‘ Strict consumer price index and Phillips curve targets.
Figure 1: Balloon of central bank balance sheets
Balance sheets in and since QE, billions of dollars (grey is US recession)
Source: Refinitiv data feed
Even as they attempt to reclaim their cherished policy rates, the road to “policy neutral” will be cut off. Real policy rates are expected to remain negative for another two years in the United States, Japan, the euro zone and the United Kingdom. For the United Kingdom, this is in addition to the 13 already experienced.
To ease some of the heavy burden of rate hikes, quantitative tightening offers a useful additional lever to pull. It needs to be stretched longer term to minimize disruptions in bond markets. In a heavily indebted world, the alternative – escalating government funding costs – would be an unfortunate consequence. To get the ball rolling, it can be helpful to get it going.
Recovering from the 2008-09 recession, the Federal Reserve was a test of how to push the two monetary levers: rate hikes and QT. Its attempt to launch QT in 2017 was abandoned after just two years, as tapering (gradually reinvesting fewer bonds) proved too destabilizing. This was at a time when policy rates were also rising, albeit slowly for a typical cycle (nine times between 2015 and 2019).
There has not yet been a significant reduction in balance sheets (Chart 1), despite the more hawkish rhetoric. The Fed’s balance sheet continues to expand, although having made its last purchases of US Treasuries and mortgage-backed securities in March, QE is officially over. But full reinvestments will persist until the Federal Open Market Committee deems it safe to gradually reinvest fewer bonds, allowing the rest to come off the balance sheet.
The main inflationary economy is the UK, a likely symptom of the net 20% fall in the trade-weighted pound since 2007. In the G7, only the UK’s GDP/CPI trade-off Italy was less good. The Bank of England looks set to continue raising rates, but with weakening UK activity data there will be a limit to that. QT can therefore be a more attractive, less visible supplement. With bond reinvestments now halted (passive QT), the process towards an active QT (asset sale) will need to be pre-announced once the BoE’s preferred signpost (a minimum 1% discount rate) is reached.
In the euro zone, the European Central Bank, until Covid-19 hit, said to be “patient on inflation (more than 2% year-on-year)”. It is now 7.5%, causing pressure to tighten. In the euro zone, the growth risk linked to QT is probably the most acute, with two-thirds of corporate borrowing based on long rates. It is the mirror image of the UK and only approached by the US, where mortgages value long-term returns. This and disparate national interests are part of why QT is unlikely to happen before 2024 at the earliest. In the meantime, net purchases under the asset purchase program will continue until July-September, although those under the pandemic emergency purchase program have stopped in March.
Japan may never reach QT. It has relied on EQ for 24 years. Without convincing inflation, it prevents it from being extinguished. And while its bond purchases have slowed, that still leaves the Bank of Japan buying bonds at about the same rate as net new supply. It owns half of the world’s largest government bond market (Chart 2), its share shrinking only as its 10-year yield target was helped by falling global yields.
Figure 2: Japan’s QE drug – the more you use it, the more you need it
JGB outstanding in yen (tn) on the left, % shares on the right
Source: Refinitiv data feed
QT’s case is also bolstered by the low true key rates are. Taking into account QE and the central banks’ own arbitrages, OMFIF believes that the United States and the United Kingdom have de facto applied negative policy rates for most of the QE period. In the UK, this is recognized by some former members of the monetary policy committee. And, with (cost-driven) inflation rising above QT, this suggests that QE-adjusted real rates could turn even more negative. He also questions the need, if the debate were to reappear, to follow the ECB and the BoJ on negative interest rates.
Such low real rates would make the US FOMC and UK MPC increasingly uneasy if QE stock remains inflated. At the heart of their reflection, it is the stock, more than the flow, of QE that counts. So it seems time to pull the QT lever.
In either case, rapid and large-scale balance sheet reduction is economically improbable and politically insane as the fiscal screw tightens, gradual rate hikes loom and elections take place in the US and UK in 2024-25. For financial markets, a triple tightening – tapering, fiscal correction and possible rate hikes – accompanied by cost inflation, social disparities and creeping protectionism, would increasingly call reflation operations into question. implemented by many asset managers.
But a positive trade-off to kick off the QT would be if policy rates could peak lower than otherwise. This could become an effective tool, especially if communicated in simple jargon, in a practical rather than conceptual way, to guide mortgage holders and other decision makers.
Resale of assets is for later and should be done gradually to minimize disruption. But, as a forerunner, passive QT might be the sweetest way to tighten up — in fact, by doing nothing. This would help keep peak rates low and reassure that central banks are not falling behind the curve. It would even go some way to reducing the downsides of QE – as evidenced by the distortions in asset prices, the removal of pressures on savings and the funding of many pension schemes.
Neil Williams is Chief Economist at OMFIF.