So, what is QT – Quantitative Tightening?
The term Quantitative Tightening or ‘QT’ seems to be slipping into the market vernacular. If it’s unfamiliar that’s probably because monetary policy, in Europe the US and Japan, since 2007 has been one of Quantitative Easing or QE.
As economies begin to expand after years of QE, fears of runaway inflation have forced central banks to normalise monetary policy and unwind their massive bond portfolios. This is a reversal of QE and is referred to as Quantitative Tightening or QT.
By exercising QT, central banks essentially take money out of the financial system. This lowers supply and drives up the costs of borrowing or interest rates.
What is the result of QT?
The result of QE was to drive up the price of assets, both bonds and shares, which benefited investors. The reversal of that process could be to drive interest rates up and asset prices down.
The Fed began the process of QT in November 2017 by allowing several billion dollars of government bonds to mature without reinvesting the proceeds. While it appears unlikely that they will actually start selling securities out of their portfolio, bonds will mature over the course of time, thus having less impact on financial markets.
QE was put into place to increase money supply from the start of the Great Recession in 2008 and continued until 2014. QT is now being applied to decrease the money supply and control inflation. As a result, access to money becomes expensive and demand for goods and services decreases.
A look back on QE – Quantitative Easing
QE is an expansionary monetary policy. Central banks make large-scale asset purchases of government bonds and other financial instruments to put liquidity into the financial system and stimulate the economy.
QE was put into place to spur economic growth. The Federal Reserve, the Bank of Japan, the European Central Bank and the Bank of England all instituted this policy.
By purchasing financial assets, usually sovereign debt, bonds, as well as equity in Japan, central banks made money more available to borrowers.
According to a Yardeni Research Inc. report¹, the collective balance sheets of the Fed, the ECB and the BOJ have more than quadrupled over the past 10 years. They have grown from a little more than US$3 trillion in early 2007 to US$14.6 trillion in January 2018.
Debt and Inflation
The resultant increase in money supply coupled with low interest rates led to in an increase in borrowing from both business and consumers. While some debt is good, too much debt can put strain on an economy as well increase government deficits.
A by-product of QE however, is higher inflation. While money supply increases, the amount of goods stays the same. Prices of goods increase as competition for each good develops, which leads to inflation.
Uncertainty of effects of QT
Like QE back in 2008, QT has never been done before on a massive scale. So, the end results are yet to be known.