MNI INTERVIEW: Active QT Can Aid Hikes Without Market Turmoil

Central banks which sold bonds bought during Covid-19 rather than passively letting them roll off their books saw more tightening of financial conditions and lowered their balance sheets faster with minimal market disruption, Matthew Luzzetti of Deutsche Bank, co-author of new research on the global impact of QT, told MNI.

Post-pandemic QT across advanced economies has supported central banks’ objective of tightening monetary policy to fight inflation, lifting yields and somewhat tightening financial conditions, according to one of the first papers to analyze the new policy lever globally. All this was accomplished with limited adverse effects on market functioning so far.

In designing future QT programs, "one question for policymakers is: do they want QT to support policy goals of the policy rate -- do they want to actively help tighten financial conditions? If they do, active sales do help steepen the curve more and increase yields more," Luzzetti said.

After the financial crisis, a number of central banks experimented with QE but the Federal Reserve was the only one to reverse some of those purchases, from 2017 to 2019. Officials were careful to differentiate QT from rates policy, with QT intended to be as boring and predictable as "watching paint dry.”

"But this time around,” according to Luzzetti, “central bankers were more openly talking about QT supporting financial conditions, and that's an important channel through which QT works its ways."

HOW QT WORKS

In 2022 and 2023, central banks announced and implemented QT in various ways with very different effects, including on the behavior of investors, the paper found. But broadly speaking, QT announcements corresponded to small increases in government bond yields and implementation saw modest rises in overnight funding spreads and reductions in the “convenience yield” of government debt.

By most other measures, however, the effects of QT have been small or nonexistent on average -- and much less than the impact of QE, according to the paper.

"What our results find is the term premium does rise some in response to QT announcements, and even more for announcements of active QT, but that the effects are generally small and statistically insignificant," said Luzzetti, referring to the conventional wisdom among economists of how both QE and QT work.

That's not to say the Fed's QT program has had no effect, he cautioned. Dallas Fed President Lorie Logan, who along with Fed Governor Chris Waller are set to discuss the paper at a conference Friday, noted last year that the expectation of lower Fed asset holdings over time contributes to higher term premiums.

Rather, because the Fed tends to "drip feed" information to the market over time, less of an announcement effect can be identified. "Over long periods and particularly for QT during 2017-1019, the Fed was providing substantial information about the likely path of QT, which would have been reflected in market pricing over time and might not be fully captured by an event study," Luzzetti said.

Importantly, as the Fed reduces its portfolio, domestic nonbank investors in the U.S., led by households, have stepped in. Reallocation across different investor classes "likely does come with an important rise in term premium and tightening financial conditions over time. It’s just difficult to identify that very precisely," he said.

NO END YET

As of December 2023, central banks have reduced their balance sheets by between 5% (Australia) and 40% (Sweden) from peak levels, with New Zealand, Sweden and the UK actively selling securities, according to the paper.

With balance sheets remaining far from pre-crisis levels, markets could still turn ugly, warn Luzzetti and co-authors Wenxin Du of Columbia Business School and Kristin Forbes of MIT-Sloan School of Management. The Fed ended QT in 2019 after repo market turmoil and officials are currently preparing to slow the pace of runoffs to avoid a repeat of that experience. (See MNI: Fed Could Soon Taper QT But Halt Further Out - Staffers)

"As reserve balance get drawn down to lower levels and begin to approach ample or scarce reserve regimes, there’s certainly the prospect that the smooth process so far turns into something more disruptive," Luzzetti said.