Is aggressive tightening a major policy mistake?

Global monetary policy authorities seem to be in for a ‘major policy mistake.’ 

No, we are not referring to their grossly ignored inflationary menace or the aggressive rate hikes that are driving us towards a global recession. 

It’s the ongoing Quantitative Tightening (QT) exercise, where global central banks are withdrawing excess money they printed in the past two years. The trouble, is such an activity on a global scale, is happening for the first time and none have a clue about how it’ll eventually end. 

On their part, policymakers are giving firm assurances about painless liquidity normalisation, but these very authorities first printed money without considering its inflationary impact and next brushed price rise as temporary only to be proved wrong on both counts. Their latest advocacy about QT causing little disruption is being viewed with disbelief and the possibility of them being right or wrong are equal simply because the theoretical or practical evidence is rather limited. 

Following the Covid-19 pandemic, central banks embarked on a bond-buying blitz increasing the global stock of reserves by a massive 25%. The largest 10 economies added USD 23 trillion, of which the US Federal Reserves’ balance sheet alone doubled to USD 9 trillion. 

By purchasing long-term bonds, central banks took upon themselves interest rate risk. How? Long-term bonds have fixed rates, while interest on reserves (money that banks park with central banks) changes with monetary policy rate. During a rate hike cycle, central banks end up paying more than they earn. This is a new ground for monetary authorities too, as until a decade ago, their major liability was currency, on which they paid no interest, earned income and seldom incurred losses. But that’s about to change and if balance sheet contraction is delayed, losses are certain. 

Just how did they end up here? Traditionally, central banks reduce short-term rates to spur growth during slowdown. But during the 2008-09 global financial crisis, when things did get better despite jamming rates to zero, the Fed introduced Quantitative Easing (QE) buying long-term bonds by printing money. A decade later, when Covid-19 struck, QE became a universal crisis toolkit, even though its effects were still being debated. But all this excess money must vanish and the reverse action is referred to as QT, where central banks sell bonds and normalise their balance sheets.  

But QT and QE aren’t similar. For instance, QE is rolled out swiftly, but its rollback is gradual, which itself is a problem. According to CrossBorder Capital, monetary policymakers are in for a ‘major upcoming policy error,’ underestimating the impact of excessive QT as governments must pay higher rates to offload debt. The fallouts are less understood given that its creator -- the Fed -- attempted QT only once before! And as the Fed Chair Jerome Powell himself alluded, its effects are ‘uncertain.’

The Fed will likely offload USD 4 trillion in about two years, and it’s assumed that such a move will reduce the stock of global reserves by 5%, and lower inflation by 2%. But Barings Investments argues that there’s no academic work to prove it and instead believes, the risk of a major policy mistake by the Fed could be in the works. 

Meanwhile, India is yet again in the clear. The RBI’s balance sheet grew by an unprecedented Rs 12 lakh crore during the pandemic year FY20 and Governor Shaktikanta Das, who began shrinking the balance sheet last October, has finished the exercise. System liquidity currently is in deficit, perking up call money rates, but analysts say this is a transient situation caused due to advance tax outflows and will soon get reversed. That said, RBI’s vigilance on liquidity will be closely watched during the bi-monthly policy review next Friday. 

Global monetary policy authorities seem to be in for a ‘major policy mistake.’  No, we are not referring to their grossly ignored inflationary menace or the aggressive rate hikes that are driving us towards a global recession.  It’s the ongoing Quantitative Tightening (QT) exercise, where global central banks are withdrawing excess money they printed in the past two years. The trouble, is such an activity on a global scale, is happening for the first time and none have a clue about how it’ll eventually end.  On their part, policymakers are giving firm assurances about painless liquidity normalisation, but these very authorities first printed money without considering its inflationary impact and next brushed price rise as temporary only to be proved wrong on both counts. Their latest advocacy about QT causing little disruption is being viewed with disbelief and the possibility of them being right or wrong are equal simply because the theoretical or practical evidence is rather limited.  Following the Covid-19 pandemic, central banks embarked on a bond-buying blitz increasing the global stock of reserves by a massive 25%. The largest 10 economies added USD 23 trillion, of which the US Federal Reserves’ balance sheet alone doubled to USD 9 trillion.  By purchasing long-term bonds, central banks took upon themselves interest rate risk. How? Long-term bonds have fixed rates, while interest on reserves (money that banks park with central banks) changes with monetary policy rate. During a rate hike cycle, central banks end up paying more than they earn. This is a new ground for monetary authorities too, as until a decade ago, their major liability was currency, on which they paid no interest, earned income and seldom incurred losses. But that’s about to change and if balance sheet contraction is delayed, losses are certain.  Just how did they end up here? Traditionally, central banks reduce short-term rates to spur growth during slowdown. But during the 2008-09 global financial crisis, when things did get better despite jamming rates to zero, the Fed introduced Quantitative Easing (QE) buying long-term bonds by printing money. A decade later, when Covid-19 struck, QE became a universal crisis toolkit, even though its effects were still being debated. But all this excess money must vanish and the reverse action is referred to as QT, where central banks sell bonds and normalise their balance sheets.   But QT and QE aren’t similar. For instance, QE is rolled out swiftly, but its rollback is gradual, which itself is a problem. According to CrossBorder Capital, monetary policymakers are in for a ‘major upcoming policy error,’ underestimating the impact of excessive QT as governments must pay higher rates to offload debt. The fallouts are less understood given that its creator -- the Fed -- attempted QT only once before! And as the Fed Chair Jerome Powell himself alluded, its effects are ‘uncertain.’ The Fed will likely offload USD 4 trillion in about two years, and it’s assumed that such a move will reduce the stock of global reserves by 5%, and lower inflation by 2%. But Barings Investments argues that there’s no academic work to prove it and instead believes, the risk of a major policy mistake by the Fed could be in the works.  Meanwhile, India is yet again in the clear. The RBI’s balance sheet grew by an unprecedented Rs 12 lakh crore during the pandemic year FY20 and Governor Shaktikanta Das, who began shrinking the balance sheet last October, has finished the exercise. System liquidity currently is in deficit, perking up call money rates, but analysts say this is a transient situation caused due to advance tax outflows and will soon get reversed. That said, RBI’s vigilance on liquidity will be closely watched during the bi-monthly policy review next Friday.