Quantitative tightening (QT) is when central banks let assets run off their balance sheets. It is the opposite of quantitative easing.
As part of quantitative tightening, central banks don’t roll over assets like government bonds and mortgage-backed securities. This is usually done after weathering an economic crisis. Quantitative tightening contracts the money supply and puts upward pressure on interest rates.
In response to the Global Financial Crisis of 2008, the Federal Reserve engaged in quantitative easing for the first time in its history. Federal Reserve: “Federal Reserve announces it will initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises and mortgage-backed securities … Continue reading Japan had already experimented with quantitative easing in the early 2000s. Bank of Japan: “New Procedures for Money Market Operations and Monetary Easing” Accessed May 23, 2022. But until 2008, most central banks other than the Bank of Japan had never made use of it.
Quantitative easing is the process of central banks purchasing assets like government bonds and mortgage-backed securities.
In 2008, the Federal Reserve announced its QE1 program. Between 2008-2015, the Fed launched several additional quantitative easing programs to deal with the aftermath of the Global Financial Crisis. By the end of QE1, the Fed had purchased $1.2 trillion worth of assets. Federal Reserve: “Review of Monetary Policy Strategy, Tools, and Communications” Accessed May 23, 2022.
When central banks purchase assets as part of quantitative easing, the money they use for the purchases is newly created. This allows central banks to supply struggling financial institutions with liquidity.
When the economy and banking system is flush with money, this can help offset the effects of a financial crisis. While some criticize this theory, most mainstream economists and central banks believe that expansionary monetary policy is necessary during economic downturns. Bernanke, Ben S. et al.: Firefighting. The Financial Crisis And It’s Lessons (2019), pp. 32ff.
At least when financial crises and economic downturns pose systematic risks, central banks shouldn’t wait too long before intervening in the economy. According to proponents of government and central bank intervention, this sometimes requires extraordinary measures.
At the time of the Global Financial Crisis, Ben Bernanke was chair of the Federal Reserve. He believed that the Great Depression could have been prevented or significantly shortened with a more swift and aggressive intervention by the Fed. Federal Reserve Bank of St. Louise “Deflation: Making Sure “It” Doesn’t Happen Here : Remarks before the National Economists Club, Washington, D.C.” Accessed April 28, … Continue reading
Aiming to prevent a collapse of the global financial system, the Federal Reserve began purchasing government bonds and mortgage-backed securities.
At the time, mortgage-backed securities were in a free fall because many of the subprime mortgages they were based on defaulted. As home owners in the United States defaulted, the value of mortgage-backed securities plummeted.
Many banks and non-financial institutions had invested in mortgage-backed securities thinking they were low-risk investments. Any institution that had significant exposure to these “toxic assets” was in trouble.
This posed the risk of contagion spreading throughout the global economy, leading to a collapse of the financial system and another deflationary depression.
To contain the crisis, the Fed aggressively purchased mortgage-backed securities. In other words, the Fed took these “toxic assets” on its own balance sheet. And it did so with newly created money. This took pressure away from institutions that were exposed to mortgage-backed securities.
Banks and non-bank financial institutions received new base money from the Federal Reserve. In exchange for the new base money, the Fed took the ‘toxic assets’ on its own balance sheet.
In 2015, the Fed began raising the federal funds rate. Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed April 22, 2022. It also began tapering its asset purchases. Tapering and quantitative tightening are not the same thing.
Tapering is the process of gradually reducing the amount of asset purchases every month. When the Fed tapers, it is still purchasing assets but at a slower rate. Quantitative tightening, on the other hand, is when the Fed sells assets or lets them run off its balance sheet. This is the opposite of quantitative easing.
While quantitative easing expands the money supply, quantitative tightening contracts the money supply. Quantitative easing has the side effect of pushing down interest rates. Quantitative tightening has the reverse effect on interest rates, pushing them up.
Central banks usually engage in quantitative tightening once the financial or economic crisis is contained. When deflation isn’t a risk anymore and the financial system and economy have recovered, central banks tighten monetary policy.
After engaging in quantitative easing, a central bank usually first tapers its asset purchases and announces one or several rate hikes.
Central banks do this to prepare investors for what is to come and avoid unexpected surprises. Similar to a depressed patient coming off of anti-depressants, a gradual reduction in asset purchases ensures a smooth and painless adjustment process.
Once the tapering process is complete, the central bank might decide to further tighten monetary policy by reducing its balance sheet and getting rid of assets.
Even after the tapering has completed, the central bank is left holding a significant amount of assets. At the same time, financial institutions, and in some cases the broader economy, experiences an increase in the supply of money.
If this increased money supply persists for too long, and works its way through the broader economy, this can cause consumer price inflation.
To avoid heightened inflation and prevent the economy from overheating, a central bank might decide to let some or all of its recently purchased assets run off its balance sheet.
In other words, once the assets purchased by the central bank mature, the central bank doesn’t roll them over. For example, if a central bank purchased government bonds, it might decide not to roll them over at maturity.
In other cases a central bank might outright sell assets. The effect is the same. Whether assets aren’t rolled over or outright sold, the balance sheet of the central bank shrinks.
This leads to a contraction of the money supply. It can help ease inflationary pressures caused by quantitative easing and low interest rates.
After launching a series of quantitative easing programs in response to the Global Financial Crisis, the Fed began quantitative tightening in 2018. Federal Reserve Bank of St. Louis: “Assets: Total Assets: Total Assets (Less Eliminations from Consolidation): Wednesday Level” Accessed May 23, 2022.
However, in 2019 the Fed stopped quantitative tightening due to negative effects it caused in the financial system. The repo rate spiked significantly. This was a sign of financial distress, which led the Fed to abandon its quantitative tightening efforts.
The Fed deployed quantitative easing for the first time in 2008. Due to the recency of its purchases, it doesn’t have much experience with quantitative tightening and how it affects financial markets and the economy. Both quantitative easing and quantitative tightening are recent interventions in the Fed’s history.
In a crisis that poses systemic risk, the Fed often resorts to quantitative easing fast and decisively. But when the Fed lets assets run off its balance sheet, it does so slowly and cautiously.
Since the effects and implications of quantitative tightening are largely unexplored, the Fed could accidentally “break” something if it shrinks its balance sheet aggressively.
This was the concern when the repo market showed signs of distress. Once the Fed reversed its quantitative tightening policy, the repo rate normalized. But it is unclear if this happened because the Fed reversed its monetary policy.
One year after the Fed stopped with quantitative tightening, it launched another major quantitative easing program in March 2020 in response to the Covid-19 pandemic. Federal Reserve: “Federal Reserve issues FOMC statement” Accessed April 8, 2022. This time the fed purchased $120 billion worth of assets per month.
But by the end of 2021, inflation reached a 40-year peak. Pressure grew to get inflation under control. While monetary theories of inflation suggest that quantitative easing caused the high inflation numbers, the Biden administration mostly attributes the high inflation prints to supply chain issues and the war in Ukraine.
Regardless of the causes of inflation, the Fed announced end of 2021 that it would conduct several rate hikes in 2022 and shrink its balance sheet through another round of quantitative tightening. Federal Reserve: “Federal Reserve issues FOMC statement” Accessed April 8, 2022.
These announcements and actions led to a broad sell off in stocks and other assets. Similar to 2019, the Fed began gradually tightening its monetary policy while remaining cautious about signs of distress in financial markets and the economy.
Stocks selling off by itself isn’t a sign of financial distress. This might be a necessary price correction after financial markets overheated due to loose monetary policy.
Individual companies going bankrupt and financial institutions becoming insolvent isn’t necessarily a sign of financial distress either. Only if the Fed’s quantitative tightening begins posing a systemic risk, or once inflation is under control, the Fed might end quantitative tightening and reverse its policy.
Quantitative easing and tightening are opposite processes. When the Fed engages in either of them, it has to carefully consider unwanted side effects. Conducting monetary policy is a delicate balancing act.
Since 2008, the Fed hasn’t been able to considerably reduce its balance sheet. However, unlike in 2019, pressure to keep inflation under control remains high.
The quantitative tightening of 2022 is the second attempt by the Fed to run assets off its balance sheet since the Global Financial Crisis. Whether and how these efforts will succeed at bringing inflation under control is yet to be seen.
The quantitative tightening of 2022 is an experiment in monetary policy that is still in the making. It will likely be talked about for a long time.
|↑1||Federal Reserve: “Federal Reserve announces it will initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises and mortgage-backed securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae” Accessed May 23, 2022.|
|↑2||Bank of Japan: “New Procedures for Money Market Operations and Monetary Easing” Accessed May 23, 2022.|
|↑3||Federal Reserve: “Review of Monetary Policy Strategy, Tools, and Communications” Accessed May 23, 2022.|
|↑4||Bernanke, Ben S. et al.: Firefighting. The Financial Crisis And It’s Lessons (2019), pp. 32ff.|
|↑5||Federal Reserve Bank of St. Louise “Deflation: Making Sure “It” Doesn’t Happen Here : Remarks before the National Economists Club, Washington, D.C.” Accessed April 28, 2022.|
|↑6||Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed April 22, 2022.|
|↑7||Federal Reserve Bank of St. Louis: “Assets: Total Assets: Total Assets (Less Eliminations from Consolidation): Wednesday Level” Accessed May 23, 2022.|
|↑8||Federal Reserve: “Federal Reserve issues FOMC statement” Accessed April 8, 2022.|
|↑9||Federal Reserve: “Federal Reserve issues FOMC statement” Accessed April 8, 2022.|