How will the end of easy money pan out?

Minutes from the Fed meeting shows that it plans to shrink the central bank's balance sheet faster than expected to tackle inflation. Alex Rankine explains what is going on.

“The world’s central bankers… are starting to see sense,” says Hamish McRae in The Mail on Sunday.

Minutes from the March meeting of America’s Federal Reserve show that policymakers plan to shrink the Fed’s $9trn balance sheet faster than anticipated in response to soaring inflation. The balance sheet is made up of assets, principally US government bonds and mortgage-backed securities, which the Fed has bought during multiple rounds of quantitative easing (QE).

Now QE is to be replaced by quantitative tightening (QT). “Officials broadly agree the Fed should shed up to $95bn of assets a month,” with the reductions to begin gradually next month, say Colby Smith and Kate Duguid in the Financial Times.

The Fed can reduce its bond holdings by not reinvesting the proceeds of bonds as they mature, or by selling some of them outright. There may be unexpected accidents. In 2019, the last time the Fed was trimming its balance sheet, short-term funding markets briefly seized up after the flood of bonds unleashed on markets caused a cash shortage.

Unclear consequences

Ultra-loose monetary policy has underpinned record US stock returns. Now the rush to tighten policy is casting a cloud over equities. America’s S&P 500 index is down 2.5% since the start of April, with the Nasdaq Composite falling more than 5%. The Fed waited the best part of a decade to begin reversing its financial crisis-era QE. This time it plans to go much faster. Developed countries’ central banks have bought about $12trn in bonds since the pandemic began, says The Economist.

Reversing trillions of dollars of asset purchases might seem like a powerful way to contain inflation.” Yet the way QE works – and hence the effect of unwinding it – is little understood.

One theory is that central-bank bond buying shrinks the “term premium” on bonds, effectively a way of cutting long-term borrowing costs. But research by Dario Perkins of TS Lombard finds that the term premium does not in fact track the size of central bank balance sheets, suggesting QE may have less impact on bond markets than theorised. Another theory is that by inflating asset prices and pushing investors into riskier securities QE helps loosen financial conditions, says Neil Shearing of Capital Economics.

Alternatively, maybe QE is a way for central banks to signal that they are committed to keeping interest rates low. Ultimately no one is quite sure how it works. “It’s therefore impossible to determine how a given amount of QT will affect financial conditions.”

If QE is less important than widely believed, then QT may likewise prove “to be a damp squib”. The US has only been through QT once before, in 2017-2019, says Justin Lahart in The Wall Street Journal. That went relatively smoothly.

But in 2013 the mere hint that the Fed might begin tapering asset purchases sent US bond yields soaring and caused chaos in emerging markets, an event known as the “taper tantrum”. The Fed’s surprise rush into QT this time feels more like the 2013 episode. Investors may not know what will happen when QT begins, but they do “know that they don’t like it”.

Recommended

What to do as the age of cheap money and overpriced equities ends
Investment strategy

What to do as the age of cheap money and overpriced equities ends

The age of cheap money, overpriced equities and negative interest rates is over. The great bond bull market is over. All this means you will be losin…
29 Sep 2022
These 3 top value stocks offer
Share tips

These 3 top value stocks offer

Professional investor Adam Rackley of Cape Wrath Capital highlights three overlooked value stocks to buy.
29 Sep 2022
Why everyone is over-reacting to the mini-Budget
Budget

Why everyone is over-reacting to the mini-Budget

Most analyses of the chancellor’s mini-Budget speech have failed to grasp its purpose and significance, says Max King
29 Sep 2022
Bank of England spends £65bn to “restore orderly market conditions”
Budget

Bank of England spends £65bn to “restore orderly market conditions”

The Bank of England has said it will spend £65bn buying bonds to stabilise the financial markets after the government’s mini-Budget. Saloni Sardana ex…
29 Sep 2022

Most Popular

Earn 4.1% from the best savings accounts
Savings

Earn 4.1% from the best savings accounts

With inflation topping 10%, your savings won't keep pace with the rising cost of living. But you can at least slow the rate at which your money is los…
27 Sep 2022
How the end of cheap money could spark a house price crash
House prices

How the end of cheap money could spark a house price crash

Rock bottom interest rates drove property prices to unaffordable levels. But with rates set to climb and cheap money off the table, we could see house…
28 Sep 2022
What changes to the pensions charge cap mean for you
Pensions

What changes to the pensions charge cap mean for you

The government could raise the pensions charge cap – the amount you can be charged in your workplace's default pension fund. Saloni Sardana explains w…
27 Sep 2022