Ever since central banks responded to the global financial crisis of 2007 and 2008 by buying securities in the open market to lower interest rates and to give a jolt to the economy, the world has got used to the term “quantitative easing”. Today, another term is making the rounds: “quantitative tightening” (QT).
In recent months, the US Federal Reserve and other leading central banks have not only stopped the asset purchases central to quantitative easing (QE) but are now shrinking their balance sheets – in some cases, aggressively.
But while the policy goes hand in hand with central banks’ priority of combating rising inflation, concern is mounting about both the pace and extent of recent QT.
“Speed is a risk,” says Jonathan Pingle, Chief US Economist, UBS Global Research. “When you go fast, you compress considerably the distance between warning signs and potential stress in the funding markets.”
Although at the moment Europe and the US have diametrically opposed issues, liquidity could become a problem very quickly.
In the case of the Fed, QT has been draining reserves from the banking system roughly twice as fast as when it last tried to soak up excess liquidity in 2018 and 2019. Moreover, and with bank reserves now below the equivalent of 12 per cent of gross domestic product (GDP), liquidity levels are reaching the 11.5 per cent threshold that the Fed considers a critical level.
The eurozone is currently facing a very different scenario, with about €4.5tn in excess liquidity. Yet as Simon Penn of UBS Knowledge Network points out, things could change very quickly. Thanks to a provision created by the region’s European Central Bank (ECB) for commercial banks to repay the loans they took at the onset of the COVID-19 pandemic, the ECB’s balance sheet could shrink 10 per cent in the short term – and between 20 per cent and 25 per cent over the next 18 months.
“All that could happen in the blink of an eye,” says Penn who recently moderated a panel entitled “Market Impact from Global Liquidity Withdrawal” at the UBS European Conference. “So, although at the moment Europe and the US have diametrically opposed issues, liquidity could become a problem very quickly.”
Why does any of this matter? As banks need to borrow against a backdrop of increasing scarcity, the financial system begins to feel increasingly constrained, which starts to push up overnight interest rates – a phenomenon with the potential to transmit to other types of short-term borrowing rates.
One consequence of all of this says Pingle, is the potential for increased volatility in overnight funding markets where trillions of dollars are financed and rolled over every day on a global level. “You really don't want to inject a volatility premium into the pricing of these markets, or make these borrowers feel like there's something unstable or unsure.”
That is precisely what happened in 2019, when Fed policy to shrink its balance sheet led to a number of banks starting to borrow funds in April and May, pushing up interest rates which led to a crunch in September of that year as overnight rates spiked – and by percentage points.
Ultimately argues Penn, the issue of reserve levels touches a far deeper question about the nature of economic growth since the financial crisis of 2007 and 2008 – the fact that indebtedness since the crisis has been built on QE, with lending climbing progressively higher on the back of ever-bigger reserves.
You really don't want to inject a volatility premium into the pricing of these markets.
“The big risk is that if you really want to deal with all the lending that was done on the back of QE, you need to reset the system through a global-wide deleveraging – and that means in all formats, from mortgages and buy-to-lets to profitless tech and Special Purpose Acquisition Vehicles (SPACs),” he says. “The key issue is that central banks originally considered QE as an emergency policy tool but now it’s just a go-to.”
For now at least, there is no sign that the Fed will change tack. Given that the balance sheet expanded so much in previous years, there continues to be a sense that there is still room for shrinking it down. Besides, and like other leading central banks, the Fed’s overriding priority is to tackle inflation which is currently running at its highest in more than 40 years.
In response it has raised the federal funds rate by 3.75 percentage points in less than a year, introducing 0.75 percentage point increases as an unmistakable signal of its intent to bring inflation under control.
Yet while not yet a problem, per se, the issue of shrinking reserves – and its effect on the overall banking system – is likely to appear ever clearer on the Fed’s radar. One set of measures it will be monitoring closely, for example, are the overnight rates that banks are willing to pay, as well as whether a number of them start to overdraw on their accounts at the Fed – something they are officially able to do.
Pingle believes that such warning signs will be enough to change the Fed’s mind, and probably by mid-2023 – earlier than consensus forecasts suggest. “We expect them to stop because of these risks that centre on emerging scarcity,” he says. “In the end, prudence will win the day.”
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