LONDON (CNN) Central banks have twice been credited with averting a global depression in the last 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 the banks into the economy amounted to a high-risk experiment — one that may not be reversed without destabilizing the financial system.
Central banks bought tens of trillions of dollars worth of government bonds and other assets to lower longer-term borrowing costs and boost their economies. Known as “Quantitative Easing” or QE, this action led to a flood of cheap cash and gave policymakers new leverage over the markets. Investors dubbed it the “easy money” era.
But since inflation last year hit its highest level in a generation, central banks have set out – on an unprecedented scale – to shrink their bloated balance sheets by selling securities or allowing them to mature and get off their books . According to a recent analysis by Fitch Ratings, “quantitative tightening” or QT by leading central banks will suck $2 trillion in liquidity from the financial system over the next two years.
A liquidity outflow of this magnitude could add to the strain on the banking system and markets already grappling with soaring interest rates and nervous investors.
“There are concerns that we are in uncharted territory,” said Raghuram Rajan, the former Reserve Bank of India governor, who presented a paper on these risks at last year’s central bankers’ meeting in Jackson Hole, Wyoming. He pointed out that “unintended consequences” are likely if QT persists.
Inflated balance sheets
Between 2009 and 2022, purchases of long-dated government bonds and assets such as mortgage-backed securities According to Fitch, payments made by the US Federal Reserve, Bank of England, European Central Bank and Bank of Japan totaled a staggering $19.7 trillion.
Now, with the exception of the Bank of Japan, the world’s most influential central banks 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 the paint dry” and described the process as “something that happens quietly in the background”. Rajan, now a professor of finance at the University of Chicago, disagrees. Investors and banks tailor their strategies to the money supply in the financial system, he noted.
“The problem is that the demand for liquidity is increasing and it’s very difficult to get the system out of it,” Rajan told CNN, comparing QE to an “addiction.”
A mere hint from the Fed that it intended to slow the pace of its asset purchases in 2013 led to the so-called “taper tantrum,” with investors looking to dump US Treasuries and stocks.
And when the central bank attempted QT and reduced its balance sheet between 2017 and 2019, some markets soon ran into trouble. In September 2019, for example, the US day loan market, which banks use to borrow money quickly and cheaply for short periods, unexpectedly came to a standstill. The Fed had to intervene with an emergency injection of liquidity.
Ultimately, according to Gary Richardson, an economics professor at the University of California, Irvine, there is “a lot of uncertainty” as a period of “very easy money” ends and a new chapter begins.
signs of overload
According to some experts, the destabilizing effects of QT were manifested in two episodes of acute market stress in the last eight months.
A sharp sell-off in UK government bonds (gilts) last September – which sent the pound plummeting and necessitated repeated intervention by the Bank of England – was prompted in part by fears over former Prime Minister Liz Truss’ plans to increase government debt along with the bank of England was about to start selling government debt. Investors expected that an oversupply of government bonds would reduce their value.
The crisis “revealed the risk of disorderly momentum” in government bond markets during the QT and should serve as a “wake-up call,” Fitch analysts said in their report.
The Bank of England building in London
QT is also contributing to the turmoil in the US banking sector, exposing weaker players like Silicon Valley Bank, which failed in March, Rajan said. Bank deposits surged during the easy money era, piling up liabilities well in excess of the amounts insured by the federal government. Then central banks began to withdraw liquidity from the financial system. This creates a dangerous imbalance when depositors suddenly demand their money back.
Worse still, many banks have large holes in their balance sheets because central banks have simultaneously hiked interest rates. Higher interest rates have depreciated the value of a significant portion of bank investments, including long-dated government bonds that were once considered safe.
“My advice has always been, ‘Don’t do a QT until you’ve got your interest rates fixed,'” Rajan said. “Doing both at the same time makes things much more complicated and could lead to problems.”
What could happen?
Central bankers say they are taking a phased and predictable approach to QT to minimize disruption.
“We’ve tried to set the signs on the route map,” Dave Ramsden, deputy governor for markets and banking at the Bank of England, told Britain’s Parliament on Thursday.
In a note to clients this week, Jennifer McKeown, global chief 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 has been “modest,” she wrote.
Nevertheless, the markets remain fragile. The International Monetary Fund said in its Financial Stability Report last month that QT has reduced liquidity in government bond markets in the euro area, the United States and the United Kingdom, making them vulnerable to unusually large price swings.
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The UK crisis in September also showed that not only investors are exposed to the risks of QT. Politicians should also take the ongoing paradigm shift into account.
While government debt has skyrocketed in recent years, central banks’ willingness to buy large chunks of it has lowered the cost of servicing it. Now governments have to find other buyers if they want to finance green investment projects or measures to digitize their economy.
Richardson of the University of California, Irvine believes central bankers’ new approach could become a major source of conflict in the United States, even if the dispute over the country’s debt ceiling is settled.
“If our central bank stops buying all these bonds, the interest on the debt will be much, much higher,” he said. “Eventually the Fed will get into politics.”
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