Central Banks May Be Underestimating Quantitative Tightening's Impact

Central banks, including the Federal Reserve, ECB, and Bank of England, have implemented quantitative tightening to shrink their balance sheets. Economist Tomasz Wieladek argues that central banks may have underestimated the impact of QT on bond yields and interest rates.

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Mahnoor Jehangir
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Central Banks May Be Underestimating Quantitative Tightening's Impact

Central Banks May Be Underestimating Quantitative Tightening's Impact

Central banks, including the Federal Reserve, European Central Bank (ECB), and Bank of England, have implemented quantitative tightening (QT) to shrink their balance sheets by not reinvesting maturing government debt or selling bonds. This reversal of quantitative easing (QE), which was adopted during the global financial crisis and COVID-19 pandemic to stimulate the economy, has led to rising yields that move inversely to prices. While central banks believe QT has worked without disrupting financial markets, economist Tomasz Wieladek argues that their confidence in QT's small effects may be misplaced.

Why this matters: The impact of quantitative tightening on bond yields and interest rates has far-reaching implications for the global economy, affecting borrowing costs and investment decisions. If central banks have underestimated QT's effects, it could lead to unintended consequences, such as tighter monetary policy and slower economic growth.

The ECB and Bank of England have accelerated the pace of QT, citing its effectiveness. However, bond markets have suffered significant sell-offs during QT, making it difficult to disentangle the effects of QT from expectations of policy rate rises. Estimates of QT's impact on yields vary widely, ranging from 10 basis points in Britain to 60-70 basis points in the euro area. Research suggests the overall effect of QT could be larger, around 30 basis points per 3% of GDP worth of QT.

The share of Bunds (German government bonds) available for private sector purchase has fallen from 72% in 2011 to around 40% now. International spillovers may amplify the effect of QT, with bond yields having a stronger correlation across countries than policy rates do. Wieladek warns, "The mid-range in current estimates... seems in line with the conventional view that the effects are likely to be modest." However, he argues that the cumulative effect of QT could lead to long-term interest rates that are 50-100 basis points higher than if there had been no QT.

The implications of underestimating QT's impact are significant. Central banks may have tightened monetary policy more than intended, solely based on the policy rate. This could require them to cutpolicy ratesfaster to meet their inflation targets. As the British Parliament's Treasury Committee noted,"QT is a leap in the dark. "Central banks must carefully monitor QT's effects to avoid unintended consequences for financial conditions and the broader economy.

Key Takeaways

  • Central banks' quantitative tightening (QT) may have underestimated impact on bond yields and interest rates.
  • QT's effects on yields vary widely, ranging from 10 to 70 basis points, with potential for larger impact.
  • International spillovers may amplify QT's effects, leading to higher long-term interest rates.
  • Underestimating QT's impact may lead to unintended consequences, such as tighter monetary policy and slower growth.
  • Central banks must carefully monitor QT's effects to avoid disrupting financial markets and the economy.