Unwinding Quantitative Easing: Challenges and Uncertainties for Central Banks

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As central banks around the world begin the challenging task of unwinding the unprecedented measures taken during the global financial crisis and the COVID-19 pandemic, concerns are mounting about the potential risks and uncertainties they face. The massive purchases of government bonds and other assets, known as quantitative easing (QE), were successful in restoring confidence and stimulating economies. However, the process of scaling back these measures, known as quantitative tightening (QT), presents new challenges that could destabilize the financial system.

Over the years, central banks such as the US Federal Reserve, the Bank of England, the European Central Bank, and the Bank of Japan accumulated a staggering $19.7 trillion in long-dated government bonds and assets like mortgage-backed securities through QE. Now, these influential central banks, except for the Bank of Japan, are gradually reducing the size of their balance sheets, uncertain of the consequences of withdrawing liquidity from the financial system.

While some have likened the process of QT to “watching paint dry,” the reality is far more complex. Investors and banks have become reliant on the abundant liquidity provided by QE, and adjusting strategies to cope with changes in the money supply can be challenging. Even a mere indication of reducing asset purchases in 2013 resulted in the “taper tantrum,” causing investors to sell off US government bonds and stocks.

The previous attempt at QT by the US Federal Reserve between 2017 and 2019 was not without consequences. It led to unexpected turmoil in the US overnight lending market in September 2019, requiring the Fed to intervene with emergency liquidity injections. These episodes highlight the uncertainty surrounding the unwinding process and the potential for unintended consequences.

Signs of strain are already emerging. Last September, fears about increased government borrowing in the UK led to a sharp selloff in government bonds, crashing the pound and necessitating repeated interventions by the Bank of England. This crisis underscored the risks of disorderly dynamics in government bond markets during QT. In the US, QT is also exposing weaker players in the banking sector, such as the failure of Silicon Valley Bank in March. The simultaneous withdrawal of liquidity and the impact of higher interest rates are creating challenges for banks with large balance sheet holes.

Central bankers claim they are adopting a gradual and predictable approach to minimize disruption. However, the fragility of markets remains, with the International Monetary Fund warning that QT has reduced liquidity in government bond markets, making them susceptible to significant price swings.

The paradigm shift in central bank policies also has broader implications for governments. With escalating debt levels, governments relied on central banks to purchase a significant portion of their debt, keeping borrowing costs low. However, as central banks reduce their bond holdings, governments must find alternative buyers to finance green investment projects and digitization efforts. This shift could create friction, particularly in the United States, as higher interest rates on debt may clash with political considerations.

As central banks navigate this uncharted territory, there are lingering uncertainties and potential risks that require careful management. The impact of unwinding QE measures, though modest thus far, could still reverberate through financial markets. Balancing the need for stability while avoiding disruptions will be crucial as central banks adjust their policies in a post-QE era.