The Economist January 29th 2022 Finance & economics 65FromQEtoQT
C
entral bankersalmost everywhere are tightening monetary
policy to fight inflation. Markets expect interest rates to rise by
about a percentage point in America and Britain, and by a tenth of
a point in the euro area, over the course of the year. But modern
central bankers have more than one lever at their disposal. Many
in the rich world are preparing to put into reverse the almost
$12trn of quantitative easing (qe), or bondbuying, they have con
ducted during the pandemic. On January 26th the Federal Reserve
said it would end qesoon and gave guidance for the first time
about how it might shrink its balancesheet, a process dubbed
quantitative tightening (qt). Reversing trillions of dollars of asset
purchases might seem like a powerful way to contain inflation. In
fact qtwill be an unreliable tool.
Having cut interest rates nearly as far as they could go during
the global financial crisis of 200709, central banks began experi
menting with qe, which was a relatively new and poorly under
stood tool. But when the time came to tighten they preferred to
follow the normal path and raise interest rates, rather than risk the
unknown by starting qt.So they maintained the size of their bal
ancesheets by reinvesting the proceeds from maturing bonds. It
was not until rates hit 11.25% in late 2017 that the Fed let its bal
ancesheet “run off”, by stopping reinvestments. The Bank of Eng
land in 2018 said it would start qtafter rates hit 1.5%—a threshold
it never reached.
The Fed’s strategy seemed to work, but because its bonds ma
tured only gradually, it was slow. In the roughly two years for
which it was in place, the central bank’s stock of assets fell by
$710bn. qt this time will start from a much higher base. The Fed
has bought plenty more bonds during the pandemic: it now holds
some $4.5trn more in assets than in 2019. Were the glacial pace of
reduction to be repeated, the next crisis would probably strike be
fore the balancesheet had shrunk by very much.
But the thinking has changed. “The period of time between
stopping purchases and beginning runoff will be shorter, and...
the runoff can be faster,” Jerome Powell, the Fed’s chairman, said
on January 11th. The Bank of England plans to stop reinvesting the
proceeds of maturing bonds when rates reach just 0.5%, which
may happen in February (see Britain section). Even the EuropeanCentral Bank’s balancesheet is expected to shrink as it scales back
emergency loans to banks, forecasts Goldman Sachs, a bank.
What explains the desire for a quick qt? Andrew Bailey, gover
nor of the Bank of England, has warned of a “ratcheting up” of the
bank’s presence in bond markets if it never scales back its hold
ings. A committee of the House of Lords has accused the bank of
having a “dangerous addiction” to buying bonds. Most central
banks also face the prospect, as rates rise, of paying interest on the
reserves they have created in order to buy bonds via qe. They
would in effect be shouldering part of their governments’ debtin
terest costs—a role that could become uncomfortable.
Some central bankers also think that qtcould allow them to
fight inflation without raising interest rates as much as would
otherwise be necessary. “I would prefer a flatter fundsrate path
and more adjustment on the balancesheet,” said Mary Daly, presi
dent of the San Francisco Fed, earlier in January. The theory is that
qeholds down longterm bond yields, so reversing it will cause
them to rise, slowing the economy.
However, despite the enormous size of qe—and the universal
agreement that it rescued markets in spring 2020—the evidence
that it has a sustained, large effect on longterm bond yields is
thin. In theory the Fed’s bond holdings compress the term premi
um, the component of longterm bond yields that compensates
investors for locking up money for a long time. But, says Dario Per
kins of tsLombard, a research firm, the term premium does not
seem to track central banks’ balancesheets. Instead it closely fol
lows the dispersion in forecasts of inflation, suggesting that it re
flects inflation risk. If qedoes not have lasting relevance to bond
yields, neither should qt. The tenyear Treasury yield was lower,
not higher, by the end of the last round of qt. In other words, al
though the Fed held fewer bonds, their price had risen.
There is one way in which balancesheet policy has an obvious
and immediate effect: by offering a signal to investors about cen
tral bankers’ probable interestrate decisions. In a downturn
bondbuying indicates that things are really bad and so interest
rates will stay low for a long time; slowing or reversing qecan sig
nal that rate rises are coming. Perhaps the most famous market re
action to a balancesheet announcement, the “taper tantrum” of
2013, happened primarily because traders drew inferences about
the path of shortterm rates from what Ben Bernanke, then the
Fed’s chairman, said about plans to slow the pace of bondbuying.
In the late 2010s, central bankers tried to mute such signals. It
was common to refer to the Fed’s qtas happening “in the back
ground”. As inflation surged in 2021, however, they showed less
discipline. Dissenters on the Bank of England’s monetarypolicy
committee voted to end qeearly. In recent weeks ratesetters’
speculation about qtmay have helped convince traders that the
Fed really is serious about tightening policy, contributing to sharp
falls in asset prices. In its latest plan the Fed has said that interest
rates are its primary policy tool. But it has struggled to articulate
whether or not more qtmeans fewer rate rises.Balance and imbalance
Perhaps it is good that investors have woken up to the Fed’s plans
for rates. Yet pivoting to using qtand rate rises as substitutes, as
Ms Daly suggests, could put the signalling mechanism into re
verse. More qtwould mean fewer rate rises, not more, so could
cause bond yields to fall.qtwould have become, bizarrely, a
source of stimulus—thelastthing a central banker with an infla
tion problem should want.nFree exchange
Quantitative tightening is no substitute for higher interest rates