QT: what is Quantitative Tightening, or "quantitative strengthening"? How does it work and what are its objectives and risks for central banks and government bonds.
What is QT, or Quantitative Tightening
In order to hinder the increase in inflation, central banks have at their disposal a monetary policy tool which helps to control the growth of prices: Quantitative Tightening (QT) or quantitative strengthening.
This choice has already marked a change of reversal in the strategy of the Fed, the US central bank, which had spent most of the last 14 years engaged in Quantitative Easing (QE), a technique opposed to Quantitative Tightening. The ECB will follow suit, as confirmed at its meeting on 2 February, starting in March 2023.
Quite the opposite, as we said, of Quantitative Easing which allowed central banks to buy corporate and sovereign debt and inject liquidity into the market in a period of crisis. In doing so, government bonds had demand, saw prices rise and yields fall.
With the QT tool, on the other hand, a contrary mechanism is triggered: what is, therefore, in detail the Quantitaive Tightening and what effects does it have?
Quantitative Tightening (QT) refers to monetary policies that contract or reduce a central bank’s balance sheet. This process is also known as “balance sheet normalization”. In other words, the Fed (or any central bank) reduces its monetary reserves selling government bonds or allowing them to mature and removing them from its cash balances. This removes liquidity (money) from the financial markets.
This strategy is the opposite of Quantitative Easing (QE), a much more ingrained term in financial jargon since the 2008 financial crisis, which refers to the Fed’s monetary policies aimed at expanding its balance sheet.
The main objective of a central bank is to keep its nation’s economy at maximum efficiency. Therefore, its mandate is to implement policies that promote maximum employment while ensuring that inflationary forces are kept at bay.
Inflation refers to the monetary phenomenon in which the prices of goods and services in an economy increase over time. It is necessary for the growth of a healthy and stable economy, but becomes a problem when it starts accelerating to the point where it exceeds wage growth. High levels of inflation erode consumers’ purchasing power and, if not addressed, could negatively affect economic growth.
The first step that a central bank like the Fed usually takes to curb runaway inflationary pressures is rate hike on federal funds. In doing so, the central bank influences the interest rates that banks charge when they lend to their customers, both corporate and residential (e.g. mortgage rates). Raising the federal funds rate would lead to higher mortgage rates and higher monthly payments, which in turn should cause the demand for real estate to fall, resulting in lower or stabilizing prices.
In case the previous measure is not enough, central banks can resort to another way to influence higher interest rates: the process called, precisely, Quantitative Tightening (QT).
As mentioned above, this can be accomplished in two main ways:
- direct sale of government bonds in the secondary market;
- not repurchase of bonds that the central bank holds when they expire.
Both methods of implementing the QT increase the supply of bonds available on the market. The main goal is to reduce the amount of money in circulation to contain the growing inflationary forces. The process by which it is done invariably results in higher interest rates.
Knowing that supply would continue to increase through additional sales or a lack of government demand, potential bond buyers demand higher yields to purchase these offerings. These higher yields cause increased borrowing costs for consumers, causing them to be more cautious about borrowing. This should dampen the demand for goods and services, as lower demand - in theory - means stabilization or lowering of prices and inflation control.
Tapering is the transition from QE to QT. In essence, it is the term used to describe the process by which QE-enabled asset purchases are gradually tapered off.
Typically, this involves reducing the amount of maturing bonds repurchased by the central bank until it reduces to zero, at which point any further reduction becomes QT.
Like any strategy of this magnitude, QT also has some inherent risks: this process has the potential to destabilize financial markets, which could trigger a global economic crisis. Of course, any central bank wants to avoid a massive sell-off in the stock and bond markets caused by widespread panic over lack of liquidity at all. This type of event, called a "taper tantrum", occurred in 2013 when then-Fed Chairman Ben Bernanke simply mentioned the possibility of tapering asset purchases. Nonetheless, the QT remains a useful tool in trying to stem the dangers posed by an overheated economy.
With inflation traveling in the double digits in Europe, even if it is slowing down, not even the risk of recession scares the ECB, as prices are still running at a fast pace and for a lasting period.
For this reason, the governor Lagarde has repeatedly reiterated the need for a different monetary policy, which will cool down the demand and circulation of money.
The official ECB document of the meeting of 2 February states that: “The Governing Council intends to continue to reinvest in full the principal payments of maturing securities purchased under APP until the end of February 2023. Thereafter, the APP portfolio will shrink at a measured and predictable pace, as the Eurosystem will not reinvest all principal payments from maturing securities. The decline will average €15 billion per month until the end of June 2023, and its subsequent pace will be determined over time.”
In case you are interested in the world of trading and investments, you can view the offer of XTB, a regulated broker, recognized globally and fourth in the world by number of active customers. By opening an account with XTB and by making a deposit of any value, you will receive a free share with a maximum value of $30 to get you started and test yourself as an investor.
Financial instruments are highly risky. The opening of the account is subject to the positive evaluation of the adequacy of the services, verified by a test. The special offer is intended to popularize stock investing and is not an investment recommendation to purchase any specific stock.
In collaboration with XTB