Julian Herbst
London, UK
Jay Powell, the chair of the US Federal Reserve (Federalreserve on Flickr/Creative Commons license)
Feature article edited by: Herbst, Assant (Section editors)
Inflation remains one of the biggest economic issues that countries across the globe currently face. Managing it is one part of almost all central banks’ dual mandate to protect financial stability and price stability, which are often represented by employment and inflation rates respectively. Inflation remains above targets of 2% in most countries (a notable exception being China), with the OECD aggregate being 5.7%. Over the past year, central banks have been forced into a balancing act: taking measures to lower inflation while at the same time not causing a recession; which, in turn, would bring with it an increase in unemployment. The traditional tool of monetary policy has been to change several policy rates, the most important being the "base rate" of central banks, (this being the Fed Funds Rate in the US and the Bank Rate in the UK.) This rate has knock-on effects on other interest rates, from mortgage rates to bond yields.
However, after the Great Recession of 2008, banks implemented a new monetary policy tool: quantitative easing, or QE, to stimulate the sluggish economy. When rates were already at an effective zero, and, in the central banks' eyes could not be lowered, the banks embarked on a programme of purchasing long-dated securities: mainly low-risk government bonds like US Treasury bonds or UK gilts. This would boost liquidity, not only because the central bank would create money to fund its balance sheet expansion, but also because it would lower long-term interest rates, making borrowing cheaper and acting in a similar manner to a normal reduction in the base rate. QE most definitely played a role in rejuvenating economies, but its most ardent critics claim that it has now reached a watershed moment, where we realise its risks as well as its benefits.
Although it was used after the Great Depression of the 1930s in the US and even in the Roman Empire, comparatively little is known about QE. In the years after many central banks’ first QE experiment, they found that they needed to continue to buy bonds to prop up their economies. An extreme example of this is Japan, where a form of QE has been implemented since the 1980s, and despite this has had relatively stagnant growth with minimal improvement in fundamentals and a massive debt burden of over 260% of GDP. Arguably, something similar has happened both in the US and Europe in the past decade, where economies have been leaning too heavily on the cheap money introduced by QE, impacting not only themselves but also more vulnerable emerging markets.
The reason this is a problem now is inflation, which was recently at record 40-year highs in the US, the EU, and the UK. To lower it, as part of its mandate, central banks have increased their policy rates, but what is also key is reversing the liquidity QE introduced; that process is the tongue-twister of quantitative tightening, or QT, which comprises either of selling bonds or simply not buying new ones in place of those that expire. While, in theory, necessary and beneficial, QT is accompanied by a myriad of problems.
The first lies in the nature of QT. The aim of QT, to cut liquidity, is precisely the risk, in which financial instability and a market rout can occur after one part of the financial system cracks. The first of this kind was the recent banking crisis, caused by depositors fleeing from Silicon Valley Bank after heavy losses on bonds the bank had bought. Many similar institutions invested in Treasury securities without hedging against interest rate risk, and, after the sharp rise in policy rates and QT, the value of the bonds they had invested in was significantly depressed, resulting in losses in aggregate running to $620 billion at the end of 2022. That is enough to wipe out almost one third of equity capital in the American banking system.
This crisis put financial stability and inflation reduction into conflict, and currently the Fed, the ECB, and the Bank of England are having to balance between the two by raising rates slowly enough that another one of these crises does not occur. Despite specific tools to avert banking crises being available to governments (such as regulation, lending to troubled banks, and insurance), the line between monetary-policy and the listed financial stability tools blurs sometimes. Indeed, the Fed slowed its rate rises after the SVB disaster, and while between May and March its assets shrank by around $600 billion, they grew in the days after the SVB rout by $300 billion. Ultimately, the Fed will have to achieve both inflation reduction and financial stability, for if it fails in either of these aspects, it will once again be ordinary Americans who foot the country’s largest bill.
Another way QT will affect banks other than a crash in asset prices is through their reserves. For example, when the short-term FFR rises quickly, cash tends to surge into money market funds, which use the Fed’s reverse-repo facility (which is purely based on the FFR) to get overnight returns and reliable ones as well, as the US Treasury itself acts as collateral on the deal. Investors therefore choose to withdraw their money from banks, which react slower to rate rises, crunching their reserves further. If QT causes a crash, it looks like only the well prepared will survive. As Warren Buffet once said, "it is only when the tide goes out that you learn who's been swimming naked."
