With the exception of the Bank of Japan, the majority of the world’s central banks are progressively shrinking the size of their balance sheets, and no one can predict with certainty what will happen as more and more liquidity is removed from the financial system.
According to CNN, central banks have started an unprecedented scaled effort to reduce their bloated balance sheets by selling assets or letting them mature and vanish from their books since inflation reached its highest level in a generation last year.
According to a new research by Fitch Ratings, “quantitative tightening,” or QT, by leading central banks would drain $2 trillion in liquidity from the financial system over the next two years.
A liquidity loss of that size may increase pressures already being placed on the banking system and markets by a sudden rise in interest rates and uneasy investors.
A presentation on these dangers was delivered by Raghuram Rajan, the former governor of the Reserve Bank of India (RBI), at the conference of central bankers held in Jackson Hole, Wyoming, the year before. “There are concerns we are in uncharted territory,” he remarked.
As QT went on, he said that “unintended consequences” were probably going to happen.
The US Federal Reserve, the Bank of England, the European Central Bank, and the Bank of Japan together bought long-dated government bonds and assets like mortgage-backed securities for a staggering $19.7 trillion between 2009 and 2022, according to Fitch.
Janet Yellen likened QT to “watching paint dry” in 2017 and said the process “runs quietly in the background.”
Rajan disagrees and is now a professor of finance at the University of Chicago. He pointed out that banks and investors adjust their strategy in accordance with the volume of money in the financial system.
“The problem is that this demand for liquidity ratchets up, and it’s very hard to wean the system off it,” Rajan told CNN, comparing QE to a “addiction.”
Investors’ so-called “taper tantrum,” in which they dumped US government bonds and equities, was sparked by the Fed’s just hint that it will slow the pace of its asset purchases in 2013, according to CNN.
Additionally, when the central bank experimented with QT by reducing the size of its balance sheet between 2017 and 2019, turmoil in various markets quickly followed. For instance, the US overnight lending market, which banks utilize to swiftly and affordably borrow money for short periods, suddenly clogged up in September 2019. The Fed has to step in and inject cash on an urgent basis.
Gary Richardson, an economist at the University of California, Irvine, told CNN that when a time of “very easy money” ends and a new chapter starts, “there’s a lot of uncertainty” is there.
Some analysts claim that two periods of extreme market stress that occurred over the previous eight months are evidence of the destabilizing impact of QT.
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, among other factors, led to a sharp selloff in UK government bonds, or gilts, in September of last year, which crashed the pound and necessitated multiple interventions from the Bank of England.
Investors predicted that a glut of gilts would cause their value to decline.
According to Fitch analysts, the crisis should serve as a “wake-up call” since it “showed the risk of disorderly dynamics” in government bond markets under QT.
