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Call for QE, elimination of central bank assets adds new market risks

April 19 (Reuters) – Major central banks, which are already preparing interest rate hikes in the fight against inflation, are also preparing a joint withdrawal from major financial markets in a first-ever round of “tightening”. global quantitative indicator that is expected to restrict credit and add stress to an already slowing global economy.

The US Federal Reserve and its major counterparts in Europe, Japan, the UK and elsewhere have injected around $12 trillion into the financial system to combat the economic fallout from the coronavirus pandemic, buying a range of assets and, in some cases, by offering long-term loans to banks in a massive episode of quantitative easing.

With breakout inflation now the common fear, they are reversing course. Morgan Stanley analysts recently estimated that the Fed, Bank of England, European Central Bank and Bank of Japan could see their portfolios shrink by $2.2 trillion in the 12 months starting in May – the peak expected from QE.

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The International Monetary Fund on Wednesday cut its estimate of global economic growth for 2022 to 3.6% from 4.4%, and warned in doing so that changes in central bank balance sheets “could present additional challenges”.

“Clear communication on plans to unwind the unprecedented expansion of central bank balance sheets … will be crucial to avoid unnecessary market volatility,” the IMF warned. “A disorderly tightening of global financial conditions would be particularly difficult for countries with high financial vulnerabilities.”

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Estimates for the impact of “global QT” are preliminary, and the Fed in particular could be more aggressive if, as many analysts expect, it moves from simply expiring maturing securities later this year. outright sale of certain assets to speed up the process.

It’s a unique moment. The 2007-2009 global financial crisis also triggered a wave of quantitative easing, but subsequent recoveries were never strong enough or induced enough inflation to cause synchronized monetary tightening.

By removing powerful central bank buyers from markets important to setting global interest rates, such as US Treasuries, the fallout could matter.

“We need a tightening of financial conditions… But it is possible that we will see rate changes or changes in the balance sheet that induce more of an effect on financial conditions than we think,” he said. Karen Dynan during a presentation at the Peterson Institute for International Economics, where she is a Senior Fellow. One of the risks is that the impacts of QT will be felt in weaker economies with high debt levels and “trigger a wave of sovereign debt crises around the world that disrupts markets” and further tightens conditions. in developed countries.


The pandemic continues to reshape global trade with whole swaths of the Chinese economy in lockdown; the war in Ukraine has become a humanitarian tragedy affecting the flow of fuel, food and industrial minerals around the world; and inflation is at multi-decade highs, prompting central banks in developed countries to line up to quash it.

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The goal of tighter monetary policy is to slow demand, especially for credit-sensitive items like homes and automobiles, and thereby ease price pressures.

“Much of the inflation is around the world…certainly in major producing regions, including Europe,” St. Louis Fed Chairman James Bullard said earlier this month. . “We don’t want to fuel the inflation process…Naturally, many central banks are pulling out all at once. That’s appropriate.”

Adding QT to interest rate hikes is a wild card though. Policymakers and economists know the general impact – interest rates will be higher than otherwise – but the exact outcome is uncertain.

“There’s very little QT experience. There’s not much here and not much around the world,” Bank of England Governor Andrew Bailey said in March.

The BoE is already letting its balance sheet deteriorate through passive means: as bonds mature, instead of reinvesting the proceeds and maintaining the level of liquidity in the financial system, it is actually removing money from its account. and the wider economy – thus reversing the initial money creation trend made by QE – and the central bank’s balance sheet is deteriorating.

The BoE said it would start considering actively selling assets once it raises its discount rate to 1.0%. Investors expect a 25 basis point rise to 1% on May 5.

So far, the ECB has only committed to stopping net asset purchases later this year. Its balance sheet could shrink further in the coming months if banks repay long-term borrowings, as many analysts expect. Some smaller players like the Bank of Canada have also halted reinvestment.

The Bank of Japan is not about to tighten, but has slowed its asset purchases.

‘Risk of misstep’

By far the biggest player, the Fed is expected to finalize its plans at a meeting in early May. Minutes of its March discussion said policymakers broadly agreed to cut up to $95 billion a month from their holdings, or about $1.1 trillion a year.

What this means for the economy depends in part on how the markets react. From 2017 to 2019, the Fed shrunk its balance sheet by about $650 billion, but this led to a shortage of banking system reserves, a spike in short-term interest rates, and a rapid reversal to reinject liquidity – quickly – in the system.

Fed policymakers take this as a lesson learned and say they expect the process to go smoothly this time around. But it showed that mistakes can happen.

The purpose of bond buying is to help central banks ride out the impact of low interest rates, allowing them to add stimulus even after policy rates have been cut to zero. The same logic now allows them to withdraw economic support more quickly than by raising rates alone. Adam Slater of Oxford Economics estimates that balance sheet reductions in major economies could add the equivalent of 1.3 percentage points to future rate hikes.

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“The new environment of massive central bank balance sheet operations means that looking at tightening cycles only in terms of policy rates paints a very incomplete picture,” Slater wrote. “In our view, the risk of a misstep over the next two years may be higher than at any time since the 1980s.”

The result at the time? An aggressive fight against inflation triggered a recession.

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Reporting by Howard Schneider; Additional reporting by Balazs Koranyi in Frankfurt, William Schomberg in London, Leika Kihara in Tokyo and Julie Gordon in Ottawa; Editing by Dan Burns and Andrea Ricci

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