Quantitative tightening, also known as QT, refers to the process undertaken by central banks to reduce the size of their balance sheets and withdraw money from circulation in the financial system, thereby tightening the money supply. This is usually done by selling bonds or other financial assets previously purchased during periods of quantitative easing. The aim of quantitative tightening is to control inflation and normalize monetary policy after implementing expansionary measures.
The Positive and Negative Aspects of Inflation
Many advanced countries and their monetary authorities establish a moderate inflation goal approximately 2%, as this is essential for steady economic expansion. The term 'steady' is crucial because it simplifies forecasting and prospective financial strategizing for individuals and businesses.
Inflation and the Wage-Price Spiral
Inflationary pressures may escalate through a feedback loop known as the wage-price spiral. This occurs when soaring inflation expectations prompt workers to demand higher wages. As businesses try to cover the increased labor costs, they pass on the burden to consumers by raising prices, thereby diminishing consumers' purchasing power. Consequently, consumers may then demand higher wages to cope with the rising living costs, perpetuating the cycle of inflation.
Quantitative easing (QE), a contemporary monetary policy approach involving substantial purchases of assets like government bonds, corporate bonds, and even equities, is employed to revive the economy after severe recessions. However, QE carries a real risk of fueling inflation if it results in excessive economic stimulation. To combat the adverse effects of surging inflation, quantitative tightening may be necessary to reverse the impacts of QE.
HOW DOES QUANTITATIVE TIGHTENING WORK?
Quantitative tightening" refers to a central bank's selling of accumulated assets, mainly bonds, to decrease the money supply circulating in the economy. This is also known as "balance sheet normalization," where the central bank reduces its inflated balance sheet.
Objectives of Quantitative Tightening:
1. Diminish the quantum of currency in circulation (deflationary).
2. Elevate borrowing expenses in tandem with the ascending benchmark interest rate.
3. Abate the overheated economy's momentum while preserving the stability of financial markets.
Quantitative Tightening (QT) can be achieved through bond sales in the secondary treasury market, and a substantial increase in the supply of bonds tends to elevate the yield or interest rate required to attract buyers. These higher yields, in turn, escalate borrowing costs, dampen the enthusiasm of corporations and individuals who previously took advantage of generous lending conditions and near-zero interest rates. Consequently, reduced borrowing results in decreased spending, leading to a decline in overall economic activity, and theoretically, this leads to a cooling of asset prices. Furthermore, the bond selling process withdraws liquidity from the financial system, compelling businesses and households to exercise more prudence in their expenditure.
QUANTITATIVE TIGHTENING VS TAPERING
Tapering" is a pivotal phase that occurs between Quantitative Easing (QE) and Quantitative Tightening (QT), wherein substantial asset acquisitions are gradually reduced or "tapered" before eventually ceasing. During QE, proceeds from maturing bonds are typically reinvested in newer bonds, thereby injecting more money into the economy. However, in tapering, these reinvestments are gradually curtailed until they halt altogether.
The term "tapering" is employed to illustrate the gradual and incremental reduction in additional asset purchases by central banks—a process that should not be confused with "tightening," as it simply involves easing the rate of asset acquisition. To illustrate, just like lifting one's foot off the gas pedal slows the car down, tapering involves easing off on the pace of asset purchases without abruptly applying pressure to "brake" the economy.
EXAMPLE OF QUANTITATIVE TIGHTENING
Since Quantitative Easing (QE) and Quantitative Tightening (QT) are fairly modern policy tools, there really hasn't been a lot of opportunity to explore QT. The Bank of Japan (BoJ) was the first central bank to implement QE but has never been able to execute QT due to stubbornly low inflation. In 2018, the US implemented QT for a brief period, only to discontinue it less than a year later in 2019, citing negative market conditions as the reason for its abrupt end. In 2013, Fed Chairman Ben Bernanke's mere mention of tapering sent the bond market into a spin, delaying QT until 2018 as alluded to above. Therefore, the process is largely untested as the program was cut short.
Since 2008, the Federal Reserve has amassed $9 trillion on its balance sheet, only having reduced the figure slightly between 2018 and 2019. Since then, it has been one-way traffic.
Gradual expansion of the Federal Reserve's portfolio over the years (Climax nearing approximately $9 trillion)
THE POTENTIAL DRAWBACKS OF QUANTITATIVE TIGHTENING
Implementing quantitative tightening (QT) requires navigating a delicate equilibrium, carefully withdrawing funds from the system while avoiding upheaval in financial markets. Central banks must cautiously manage liquidity reduction to prevent alarming investors and causing turbulent fluctuations in the bond or equity market. This scenario precisely unfolded in 2013, as Federal Reserve Chairman Ben Bernanke simply hinted at potential future asset purchase slowdowns, triggering an enormous surge in treasury yields and subsequently driving bond prices downward.
US Treasury Yields Weekly Chart (Orange, 2yr, Blue, 5yr, 10, Year)
Such an occurrence is labeled a 'taper tantrum' and may still arise during the QT period. Another limitation of QT is that it has never been executed to its entirety. QE was introduced after the Global Financial Crisis to mitigate the severe economic downturn that followed. Instead of tightening following Bernanke's remarks, the Fed opted for a third round of QE, until more recently, in 2018, when the QT process began. Less than a year later, the Fed chose to terminate QT due to observed adverse market conditions. Consequently, the sole precedent indicates that future QT implementation could potentially yield negative market conditions once more.
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