What is Quantitative Tightening?
Definition of QT
Quantitative tightening (QT) is a contractionary monetary policy tool used by central banks to reduce the level of money supply, liquidity, and general level of economic activity in an economy.
Purpose of QT
The main purpose of QT is to combat inflation that is caused by an overheating economy. When an economy is overheating, it leads to an increase in the general prices of goods and services, resulting in inflation.
Why is it used?
The central banks use quantitative tightening as a begrudging measure when the economy is experiencing excessive inflation. By reducing money supply, liquidity, and economic activity, the central bank aims to control and stabilize the rising prices.
The risks of inflation and the wage-price spiral
When inflation expectations rise, workers often lobby for higher wages to keep up with the increasing prices. This leads to a wage-price spiral, where higher wages lead to higher prices, reducing consumers’ purchasing power. As a result, businesses adjust their wages further, aggravating the inflationary pressures.
The relationship between QT and quantitative easing (QE)
Quantitative easing (QE) is a monetary policy tool used by central banks to stimulate an economy during a deep recession. It involves large-scale asset purchases, such as government bonds, corporate bonds, and even equity purchases. However, QE can lead to overstimulation and increased inflation risks. In such cases, quantitative tightening may be necessary to reverse the negative effects of excessive QE.
How does Quantitative Tightening work?
Quantitative tightening involves the central bank selling its accumulated assets, mainly bonds, to reduce the supply of money circulating in the economy. This process is also known as “balance sheet normalization” as it aims to reduce the inflated balance sheet of the central bank.
Objectives of Quantitative Tightening:
- Reduce the amount of money in circulation (deflationary)
- Raise borrowing costs alongside the rising benchmark interest rate
- Cool down the overheating economy without destabilizing financial markets
Quantitative tightening can be implemented through bond sales in the secondary treasury market. If there is a significant increase in the supply of bonds, the yield or interest rate required to entice buyers tends to rise. Higher yields raise borrowing costs and reduce the willingness of corporations and individuals to borrow. This decrease in borrowing and spending leads to lower economic activity, ultimately contributing to a cooling of asset prices. Additionally, the process of selling bonds removes liquidity from the financial system, prompting businesses and households to be more cautious with their spending.
Differences between Quantitative Tightening and Tapering
While quantitative tightening refers to the process of reducing the supply of money and assets in an economy, tapering is the transitional period between quantitative easing (QE) and quantitative tightening (QT). During tapering, the central bank gradually reduces its large-scale asset purchases before coming to a complete halt.
The term “tapering” is used to describe the gradual reduction in additional asset purchases, not the tightening itself. It is akin to lifting your foot off the gas pedal, gradually reducing the speed of a car. Similarly, tapering involves a gradual decrease in asset purchases, slowing down stimulus measures.
Examples of Quantitative Tightening
Since quantitative tightening is a relatively modern policy tool, there have been limited opportunities to observe its implementation. The Bank of Japan (BoJ) was the first central bank to implement quantitative easing (QE), but it has not yet implemented quantitative tightening due to persistently low inflation. The United States implemented quantitative tightening in 2018, but it was discontinued less than a year later in 2019 due to negative market conditions.
In 2013, Fed Chairman Ben Bernanke’s mention of tapering caused significant disruption in the bond market, leading to a delay in the implementation of quantitative tightening until 2018. The limited examples of quantitative tightening make it difficult to gauge its long-term effects and outcomes.
Since 2008, the Federal Reserve has accumulated approximately $9 trillion on its balance sheet, with only a slight reduction between 2018 and 2019. The accumulation of assets indicates the expansive monetary policies implemented during that period.
The Potential Drawbacks of Quantitative Tightening
Implementing quantitative tightening involves finding a delicate balance between removing money from the system without destabilizing financial markets. Central banks run the risk of removing liquidity too quickly, which can spook financial markets and lead to erratic movements in the bond or stock market.
One potential drawback is the occurrence of a “taper tantrum,” similar to what happened in 2013 when Federal Reserve Chairman Ben Bernanke mentioned the possibility of slowing down asset purchases. This mere mention resulted in a massive spike in treasury yields, sending bond prices lower. A taper tantrum during the quantitative tightening period can have similar disruptive effects on financial markets.
Another potential drawback is the lack of previous examples of successfully completed quantitative tightening. After the Global Financial Crisis, the Federal Reserve initially planned to tighten monetary policy after Bernanke’s comments, but instead, they implemented a third round of quantitative easing. The limited implementation of quantitative tightening in 2018 was subsequently halted due to negative market conditions. This lack of completed examples suggests that future implementation of quantitative tightening could potentially lead to similar negative market conditions.
In conclusion, quantitative tightening is a contractionary monetary policy tool used by central banks to reduce money supply, liquidity, and economic activity to combat inflation. While it aims to stabilize an overheating economy, it carries potential risks such as destabilizing financial markets and the occurrence of taper tantrums. The limited examples of successful quantitative tightening make it challenging to assess its long-term effectiveness and outcomes.