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January 20, 2023

News in Charts: The impact of quantitative tightening

by Fathom Consulting.

The long period of quantitative easing (QE) that followed the great financial crisis when interest rates in the US, UK and the euro area were at, or close to, the zero lower bound has ended, and central banks have begun to introduce quantitative tightening (QT) and to increase interest rates to curb inflation. QT involves reducing the size of the central bank’s balance sheet, a task the various central banks are implementing in different ways: the Bank of England through actively selling bonds, and the Federal Reserve through letting securities mature without re-investing them. The ECB is planning to do the latter when it too begins QT in March. QT puts upward pressure on interest rates, as a higher supply of government bonds raises government bond yields.

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Interest rates have already increased substantially, with the Federal Reserve increasing rates by 425 basis points, the BoE by 340 basis points and the ECB by 250 basis points this cycle. There is a time lag from when interest rates increase until the full effects can be seen on economic activity. According to the ECB, the impact on inflation of a 1% increase in rates reaches its peak in the second year after the policy change. Therefore, interest rate hikes in 2022 will continue to affect economic activity into 2023 and beyond.

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As it is the first time that central banks have implemented QT (except for the Federal Reserve reducing the size of the balance sheet between 2017 and 2019), the effect of QT on the economy is uncertain. Central bankers do not know how much it will limit economic growth, or how long it will take to take effect – if at all. Therefore, it is difficult to ascertain the level of QT needed to restore low and stable inflation, and how effective it will be in achieving this goal.

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QT is the opposite of QE. Therefore, one can compare the transmission channels of QT with QE. For example, QE helps to anchor interest-rate expectations to a low level (the signalling effect). Additionally, as QE reduces the yield on government bonds, investors rebalance towards higher-yield, riskier assets (the portfolio-rebalancing effect). Whether QT has the exact opposite effect is as yet uncertain. According to ECB Chief Economist Philip Lane, the signalling effect will be less powerful in QT than QE. Additionally, according to the BoE, QE is more effective in an environment of market dysfunction, whereas QT is implemented under orderly market conditions.

While some transmission channels may be weaker for QT than QE, others may be stronger, however. QT has already had an impact on financial conditions. It reduces liquidity, increasing the liquidity premia in bond yields. The majority[1] of euro area QE involved purchasing the debt of high-debt countries such as Italy. Therefore, it is likely that QT will have a larger impact on financial conditions in those economies.

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By how much will QT limit growth if we assume that the effect will be the exact opposite of QE? For asset purchases representing 10% of GDP, real GDP increased by a cumulative 0.4%-1.8% (with non-central bank studies finding smaller effects and central bank studies finding larger effects; in Fathom’s view, the impact of QE on economic growth is probably zero).[2]  Central bank assets as a share of GDP at the end of this year will be 6% (US and euro area) and 8% (UK) lower than at their peak. Taking the mid-point of the effect of QE as our metric, this would mean that QT could reduce real GDP by between 0.5 and 1% in the euro area, UK and the US[3]. It is worth noting that multiple studies have found no statistically significant effect of QE on economic growth, consistent with Fathom’s view.

So what progress has been made so far in tackling inflation? Survey data has shown a steep decline in activity in the US, which could signal the onset of recession, as Fathom noted last week. The annual increase in US core prices was 5.7% in December, declining by one percentage point since the peak in September. Core inflation is also 1.3 percentage points lower at 4.7% if shelter is excluded (this component lags current housing market conditions due to rental agreements typically only rolling over once per year). UK GDP in November was higher than expected, but this can be explained by increased consumption during the World Cup. The euro area has remained more resilient than expected to high energy prices.

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Uncertainty regarding the effect of QT on the economy means that the terminal rate – the rate at which the policy rate will peak – remains difficult to identify. Inflation has peaked, but is still at a very high level. Moreover, there has been a vast decrease in unemployed people per vacancy in the UK and the US since the peak in April 2020, and current ratios show tight labour markets in historic terms. A tight labour market pushes up wage growth, which again puts upward pressure on inflation. Given these circumstances, and the fact that their credibility is at stake, Fathom believes that central banks are more likely to tighten too much – increasing interest rates and implementing QT – than too little in 2023.

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The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

[1] The ECB has proactively tried to limit that possibility through the creation of its Transmission Protection Instrument, which will enable it to purchase additional securities from individual countries if it considers yield increases to be “unwarranted by country specific fundamentals”.

[2] See Fabo et al, 2021 for a summary of the findings on QE.

[3] Following the approach in the literature, the denominator for both points in time is nominal GDP when central bank assets were at their peak. This is 2022 Q1 for all three central banks.

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