More quantitative tightening is expected

Central banks, such as the Bank of England and ECB, have not tried quantitative tightening before. 

This sort of talk is far sooner than we saw in the last cycle but it’s understandable and we could see other central banks as well make more use of quantitative tightening in this tightening cycle than before.

All the major central banks have made it abundantly clear that their primary monetary policy lever is still the policy rate, not asset purchases, long-term repos, other temporary loans, and more. Some central banks, such as the BoE, have started to lift rates; others will follow soon (the Fed) and still others will follow in time (the ECB). But while interest rates will remain the policy of choice, it already looks as if quantitative tightening could have a bigger role to play than in the past.

This being said, of these three central banks, it is only the Fed that has undertaken quantitative tightening so far, from October 2017 through to the advent of tensions in the repo market around two years later. Over this two-year period, the Fed only reduced its balance sheet by around 15%. Assets fell from around USD4.4 trillion when the Fed first started quantitative tightening to a low of around USD3.75 trillion two years later. Today, these assets are close to USD 8.8 trillion.

What’s more, quantitative tightening did not start until two years after the first rate hike. This time around some Fed hawks are suggesting that quantitative tightening  could start almost as soon as rates start to rise. There seem to be a number of reasons why quantitative tightening could start sooner and possibly be more aggressive than we saw in the last episode. One is that inflation is much higher now, another is that the Fed holds more short-dated bonds which will clearly run off faster.

And a third is that the Fed’s new standing repo facility gives it ample scope to ease any liquidity strains, potentially making the markets less vulnerable to a faster run-off pace or a deeper contraction of Fed assets. Other central banks, such as the Bank of England and ECB, have not tried quantitative tightening before. While the Fed was letting maturing assets roll off, other central banks were just content to hold assets steady. But even here, this is not sufficient in the upcoming tightening cycle, and active quantitative tightening will be needed as well.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy said: "Our contention has been, and still is, that central banks, and particularly the Fed, will need to undertake more monetary tightening than they, and the market, expect in order to get inflation under control when judged in terms of likely rate hikes. The Fed’s median forecast from FOMC members is for the Fed funds rate to be 2–2,5% by the end of 2024, and the market prices it even lower, at around 1,75%. In our view, the only way that this will be consistent with achieving the FOMC median PCE price forecast for 2024, which is close to the 2% target at 2.1%, is if rate hikes are supplemented by a significant amount of quantitative tightening".

From the perspective of the central banks themselves, it might also be the case that they would rather "hide" monetary tightening in the form of quantitative tightening rather than highly publicized rate hikes. In the US, for instance, the housing market is seen by many to be in a bubble. That may or may not be correct. But if the Fed wants to tighten without bursting any bubbles, it seems sensible to err more towards quantitative tightening and less towards rate hikes, as sharp rate increases – and a much higher end-point to the cycle – could rattle the market, sending it into a steep decline. In contrast, quantitative tightening is less noticeable even though, of course, it would be expected to lift yields and mortgage rates – all else equal.

"We think other central banks could use the same trick as well, certainly the Bank of England, which is already under public pressure because of sharp increases in the cost of living. Rate hikes increase the cost of living even more, via loan costs, but quantitative tightening is more of a silent assassin and we might find that the BoE – and others – have to rely on this much more than currently anticipated by investors", Mr. Steve Barrow stressed.