Central banks have been credited with averting a global depression twice over the past 15 years: Once after the 2008 financial crisis, and again at the height of the coronavirus pandemic.
But the tactics they deployed to restore confidence and keep money flowing from banks to the economy amounted to a high-stakes experiment — one that may be impossible to unwind without destabilizing the financial system.
Central banks purchased tens of trillions of dollars worth of government bonds and other assets in a bid to bring down longer-term borrowing costs and stimulate their economies. This measure, known as “quantitative easing,” or QE, created a flood of cheap cash and gave policymakers newfound sway over markets. Investors called it the era of “easy money.”
But since inflation hit its highest level in a generation last year, central banks have embarked on the quest — unprecedented in scale — of shrinking their bloated balance sheets by selling securities or letting them mature and disappear from their books. “Quantitative tightening,” or QT, by top central banks will suck $2 trillion in liquidity out of the financial system over the next two years, according to a recent analysis by Fitch Ratings.
A liquidity drain of that magnitude could amplify strains on the banking system and markets, which are already grappling with a sharp run-up in interest rates and edgy investors.
“There are concerns we are in uncharted territory,” said Raghuram Rajan, the former governor of the Reserve Bank of India, who presented a paper on these risks at last year’s gathering of central bankers in Jackson Hole, Wyoming. He noted that “unintended consequences” were likely as QT continued.
Swollen balance sheets
Between 2009 and 2022, purchases of long-dated government bonds and assets such as mortgage-backed securities by the US Federal Reserve, the Bank of England, the European Central Bank and the Bank of Japan totaled an eye-watering $19.7 trillion, according to Fitch.
Now the world’s most influential central banks — apart from the Bank of Japan — are steadily reducing the size of their balance sheets, and no one knows for sure what will happen as more and more liquidity is withdrawn from the financial system.
In 2017, Janet Yellen compared QT to “watching paint dry,” describing the process as “something that runs quietly in the background.” Rajan, now a professor of finance at the University of Chicago, disagrees. Investors and banks calibrate their strategies to the amount of money in the financial system, he noted.
“The problem is this demand for liquidity ratchets up, and it’s very hard to wean the system off it,” Rajan told CNN, likening QE to an “addiction.”
A mere indication from the Fed that it intended to reduce the pace of its asset purchases in 2013 led to the so-called “taper tantrum,” with investors dumping US government bonds and stocks.
And when the central bank tried QT, shrinking the size of its balance sheet between 2017 and 2019, trouble soon followed in some markets. In September 2019, for example, the US overnight lending market — which banks use to quickly and cheaply borrow money for short periods — seized up unexpectedly. The Fed had to intervene with an emergency infusion of liquidity.
Ultimately, “there’s a lot of uncertainty” as a period of “very easy money” ends and a new chapter begins, according to Gary Richardson, an economics professor at the University of California, Irvine.
Signs of strain
The destabilizing effects of QT are evident in two episodes of acute market stress over the past eight months, according to some experts.
A sharp selloff in UK government bonds, or gilts, last September — which crashed the pound and required the Bank of England to step in repeatedly — was triggered in part by fears about plans by former Prime Minister Liz Truss to increase government borrowing just as the Bank of England was about to start selling public debt. Investors anticipated that an oversupply of gilts would depress their value.
The crisis “showed the risk of disorderly dynamics” in government bond markets during QT and should serve as a “wake-up call,” Fitch analysts said in their report.
QT is also contributing to tumult in the US banking sector, exposing weaker players like Silicon Valley Bank, which failed in March, Rajan said. Banks saw deposits balloon during the era of easy money, piling up liabilities way in excess of amounts insured by the federal government. Then, central banks started withdrawing liquidity from the financial system. That creates a dangerous mismatch should depositors suddenly demand their money back.
Even worse, many banks have large holes on their balance sheets because central banks have simultaneously jacked up interest rates. Higher rates have eroded the value of a significant share of banks’ investments, including long-term government bonds once viewed as safe.
“My advice has constantly been, ‘Don’t do QT before you get your interest rates in order,” Rajan said. “Doing both at the same time makes things much more complicated and could create problems.”
What could happen?
Central bankers say they’re taking a gradual and predictable approach to QT to minimize disruption.
“What we’ve tried to do is set out the signs on the route map,” Dave Ramsden, deputy governor for markets and banking at the Bank of England, testified Thursday to the UK parliament.
In a note to clients this week, Jennifer McKeown, chief global economist at Capital Economics, noted that bond markets appeared to have been more sensitive to interest rate hikes than to QT over the past year. The impact of QT so far, she wrote, had been “modest.”
Yet markets remain fragile. The International Monetary Fund said in its report on financial stability last month that QT in the euro area, the United States and the United Kingdom had reduced liquidity in government bond markets, making them vulnerable to unusually large price swings.
The September crisis in the United Kingdom also showed that investors aren’t the only ones exposed to risks from QT. Politicians should also consider the paradigm shift underway.
While government debt levels have skyrocketed in recent years, the cost of servicing that debt has been tamped down by the willingness of central banks to buy large chunks of it. Now, governments need to find other buyers if they want to finance green investment projects or measures to digitize their economies.
Richardson at the University of California, Irvine, believes the new approach by central bankers could become a major source of friction in the United States, even if the fight over the nation’s debt ceiling is resolved.
“If our central bank is no longer going to buy up all these bonds, then the interest on the debt is going to be much much higher,” he said. “At some point, what the Fed is going to do is run into politics.”