Quantitative Tightening is a contractionary financial policy tool central banks use to reduce cash supply, liquidity, and economic activity level in an economy. Why would central banks resort to lowering economic activity?
They adopt that during overheated economies, triggering inflation, which means increasing the prices of services and goods bought within the local economy.
Inflation’s Yin Yang
Many developed countries and their respective central bank set 2% as a soft inflation target, and that’s because gradual upticks in prices remain essential for steady economic growth. The term ‘steady’ is crucial as it makes predictions and future monetary planning smooth for businesses and individuals.
Inflation & Wage-Price Spiral
Nonetheless, runway inflation may easily be uncontrollable when employees lobby for increased wages because of high inflation anticipations, costs that businesses pass to clients through heightened prices which decreases client buying power, eventually welcoming more wage adjustments.
Inflation is dangerous for QE (quantitative Easing), a modern financial policy tool that incorporates massive asset purchases – generally a combination of equity purchases, corporate bonds, and even government bonds – utilized to arouse the economy in attempts to revive from deep recessions.
Inflation may emerge from over-stimulation, necessitating QT (quantitative Tightening) to reverse the negative impacts (soaring inflation) of quantitative Easing.
How Does QT Work?
Quantitative Tightening (QT), also balance sheet normalization, is the process that central banks sell their accumulated assets (primarily bonds) to trim the money supply circulating within the economy. The process involves the bank reducing its inflated balance sheet.
- Reducing circulating money supply (deflationary).
- Increase borrowing costs along with increasing benchmark interest rates.
- To cool overheated economy without disrupting financial markets.
Quantitative Tightening could be done via bond sales within the secondary treasury markets. When there’s increased bond supply, the interest rate or yield needed to attract buyers tends to soar. Heightened yields increase bowling costs while lowering corporations’ appetite and people who borrowed cash when lending terms were decent, and rates hovered near zero.
Less borrowing welcomes less spending, translating to deteriorating economic activity, which cools asset prices. Further, bond selling eliminates liquidity in the financial space forcing households and businesses to be cautious when spending.
QT Vs. Tapering
Tapering often relates to the QT process, but it describes the migration phase between Quantitative Easing and Quantitative Tightening, involving tapering or cutting back large-asset asset buyers before resorting to a full halt. QE sees maturing bonds reinvested in new bonds, putting more cash into the economy. Nonetheless, tapering involves cutting back reinvestments before an eventual halt.
Potential QT Drawbacks
Implementing Quantitative Tightening involves ensuring a subtle balance between eradicating cash from the economy and avoiding financial market destabilization. Central banks indulge in the dangers of removing liquidity quicker, and that may wraith financial markets, leading to unpredictable actions within the stock and bond marketplace.
That occurred in 2013 when Ben Bernanke (the then-Fed Reserve Chair) merely talked about the chances of slowing asset buys in the future. That triggered enormous upticks in treasury yields, dragging bond prices lower.
That’s called a taper tantrum and may still materialize during QT. Another QT drawback is that any central bank has yet to complete it. Quantitative Easing emerged after the Financial Crisis, implemented in trials to cool the massive economic recession.
Rather than tightening following Bernanke’s remarks, the Federal implemented a 3rd QE until, in 2018, the Federal started the Quantitative Tightening process. Nonetheless, the Federal ended QT less than one year later, citing negative market situations. Thus, the only sample shows that future QT implementation may welcome undesirable market situations again.