Global central banks' quantitative tightening and implications for industry

At the onset of the pandemic, central banks worldwide acted swiftly to contain the economic fallout from the health crisis and support recovery. Monetary authorities immediately slashed rates to inject liquidity to markets and maintain the flow of credit.

As central banks in developed countries had less room to reduce interest rates, they turned to unconventional monetary policy tools to revive economies, mostly through purchases of treasury debt and mortgage-backed securities in what is also known as quantitative easing (QE).

This helped stabilise financial markets during the pandemic by keeping borrowing costs low especially for large consumer purchases like homes and vehicles.

As economies recover and inflation rises above target, central banks are now unwinding this accommodative policy to revert to conventional measures in a reverse process known as quantitative tightening (QT)

To prevent disruption to financial systems, however, monetary authorities are proceeding with caution, opting to slow down the pace of balance sheet reduction by not reinvesting all the proceeds of maturing bonds for several years, rather than stopping bond purchases altogether. In response to moderating inflation and weakness in economies, central banks are combining this with reductions in benchmark interest rates to support growth as excess liquidity is mopped up from the financial system.

Federal Reserve slows down balance sheet runoff pace

In 2020, the Federal Reserve injected liquidity into the economy by buying large quantities of treasury debt and mortgage-linked securities. These purchases pushed down long-term interest rates, thus encouraging car and home purchases.

As the economy recovered, the Fed began shrinking its balance sheet in June 2022 by not reinvesting all the proceeds of maturing bonds. By the end of March 2024, the Fed had reduced its assets to $7.4 trillion from a peak of nearly $9 trillion.

Beginning on 1 June 2024, the Fed started shrinking its balance sheet at a slower pace to prevent unwarranted stress in financial markets. The taper involved lowering the monthly Treasuries runoff cap to $35 billion per month from the previous $60 billion, while keeping the cap on mortgage-backed securities runoff unchanged at $35 billion per month.

Federal Reserve chair Jerome Powell has said the decision to slow down the balance sheet reduction is meant to prevent a similar market turmoil that occurred in 2019 when the Fed last shrank its balance sheet. He has said slowing the pace would allow the Fed a smooth transition and reduce the possibility of stress in money markets.

In September 2019, the US banking system experienced a “repo crisis” when there was a sharp spike in overnight loans between banks. The Fed had to step in to provide liquidity to bring down repurchase agreement (repo) rates.

On the heels of the taper, the Fed slashed interest rates aggressively on 18 September, the first rate cut since March 2020. The Federal Open Market Committee lowered its key overnight borrowing rate by 50 basis points to a range of 4.75%-5% amid indications that inflation is moderating and the labour market is weakening.

Ultra-loose monetary policies during the peak of the pandemic lowered borrowing costs and spurred investment and consumption. As central banks gradually taper large purchases of securities, bond prices would fall, but yields would rise, affecting borrowing rates.

The stock market, which tends to benefit from an easing environment, may also take a hit as higher borrowing costs and tighter liquidity may affect corporate earnings. In an easing environment, lower bond yields encourage capital allocation to equities instead.

Contractionary policies like QT in general can limit economic growth, reduce spending, and increase unemployment, all of which directly affect the banking system.

In an August 2024 commentary by Fitch Ratings, the credit watchdog said reducing the supply of reserves in the banking system through QT increases the risk of reserve scarcity, “putting upward pressure on money market interest rates.” For banks, tighter liquidity could result in restrictive credit conditions.

Fitch Ratings noted that central banks aim to avoid this risk by not reducing the supply of reserves too much and committing to end balance sheet reduction before reserves become too scarce.

EBC downsizes EUR 5 trillion ($5.5 trillion) bond holdings progressively

The European Central Bank (ECB) has been trimming its holdings under its Asset Purchase Program (APP) since March 2023.

In December 2022, the ECB Governing Council decided to reduce assets under the APP through partial reinvestment of principal repayments. As such, from March to June 2023, APP holdings were reduced by EUR 15 billion ($16.6 billion) per month.

And then, in July 2023, the ECB started to implement a full passive unwinding of assets by stopping reinvestments of principal repayments, thereby reducing holdings under the APP at an uneven pace depending on the amount of repayments in a month. From 2022 up to 2023, assets under the APP reached EUR 3.2 trillion ($3.5 trillion).

ECB is also shrinking holdings under the temporary Pandemic Emergency Purchase Programme (PEPP) which was launched in March 2020 to purchase bonds from both private and public sectors. The initial envelope of EUR 750 billion ($830 billion) was expanded to EUR 1.85 trillion ($2 trillion) to support economies in the Eurozone. In December 2023, the council decided that PEPP reinvestments would be reduced by an average of EUR 7.5 billion ($8.3 billion) per month before being fully discontinued at the end of 2024.

In a statement on 12 September, the ECB stressed the need for a measured reduction of the balance sheet to prevent adverse impact on post-pandemic monetary policy transmission—the impact of the change in monetary policy to economic activity and inflation.

The statement read: “The Governing Council will continue applying flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to countering risks to the monetary policy transmission mechanism related to the pandemic.”

To ease the effect of tightening financial conditions on economic growth, the ECB slashed interest rates again on 12 September by 25 basis points to 3.5%. This follows a similar cut in June as inflation cools and the Eurozone economy remains weak.

The widely-expected cut in the deposit paid to banks that make overnight deposits within the Eurosystem was made as inflation in the Eurozone fell to 2.2% in August from 2.6% in July, near the ECB’s target of 2%.

As financing conditions remain restrictive and economic activity still subdued because of weak private consumption and investment, the ECB downgraded its gross domestic product (GDP) growth forecast for this year to 0.8% from 0.9%. For 2025, growth projections were lowered to 1.3% from 1.4%, and in 2026, trimmed to 1.5% from 1.6%.

The ECB said: “Based on the Governing Council’s updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission, it is now appropriate to take another step in moderating the degree of monetary policy restriction.”

Financial markets, which stand to receive a boost from rate cuts, are already anticipating further reductions in the October and December policy meetings, but ECB President Christine Lagarde has said the central bank is not committing to a particular rate path and would stick to a data-dependent and meeting-by-meeting approach.

This as inflation is expected to rise again in the later part of the year as wages continue to rise, normalising only in the second half of next year.

Bank of England to reduce stock of gilts over next 12 months; Bank of Japan to steadily shrink bond portfolio

Bank of England’s (BOE) Monetary Policy Committee voted on 19 September to reduce its stock of UK government bonds, known as gilts, by GBP 100 billion ($133 billion). This would be carried out through active sales and maturation over the next 12 months.

BOE expanded its balance sheet during the pandemic as it sought to support the economy, changing course to unwinding only in February 2022.

In a statement on 19 September, BOE said reducing the size of the APF (Asset Purchase Facility) would “increase the headroom and flexibility available to the bank to use its balance sheet in the future if needed.”

BOE also held rates steady at 5% last month following a quarter point cut in August, the first since 2020. BOE governor Andrew Bailey has stressed the need for more evidence that inflation would remain low before cutting rates further. There are two more interest rate decisions this year.

In July, the Bank of Japan (BOJ) also announced that it would steadily trim its bond purchases from the current JPY 6 trillion ($41.6 billion) per month to JPY 3 trillion ($20.8 billion) per month by March 2026.

The taper is expected to reduce BOJ’s total bond holdings of JPY 600 trillion ($4.1 trillion) by 7% to 8%. The BOJ would review its bond purchase plan at its June 2025 monetary policy meeting.

In a 31 July statement, the central bank said: “In principle, long-term interest rates are to be formed in financial markets, and it is appropriate for the Bank to reduce its purchase amount of Japanese government bonds (JGBs) in a predictable manner, while allowing enough flexibility to support stability in the JGB markets.”

On 20 September, BOJ kept its benchmark rate steady at 0.25% after raising for the first time in more than a decade in July. BOJ is an outlier at a time when central banks worldwide are easing policy. This is because it has long maintained interest rates at almost zero to encourage inflation and boost economic activity with massive monetary stimulus.

In a June 2024 paper, ‘Monetary Policy in the 21^st century: lessons learned and challenges ahead’, the Bank for International Settlements (BIS) said “forceful monetary tightening” can can prevent the transition to a high-inflation regime.

“Even if central banks may be slow in responding initially, they can succeed, provided they catch up quickly and display the necessary determination to finish the job. Second, forceful action, notably the deployment of the central bank balance sheet, can stabilise the financial system at times of stress and prevent the economy from falling into a tailspin,” said the report.

Central banks worldwide are taking a measured approach to monetary policy easing after massive pandemic-era liquidity injections to avoid market stress due to the withdrawal of cash from the financial system. Along with quantitative tightening, monetary authorities seek to maintain inflation in check through careful reductions in key interest rates as it normalises policy.