Howard Schneider and William Schomberg

(Reuters) – Major central banks are already planning interest rate increases to combat inflation. They also plan to pull back from the key financial markets as part of a global round “quantitative tightening”. This is expected to reduce credit availability and stress an already slowing economy.

To combat the effects of the coronavirus pandemic on the economy, the U.S. Federal Reserve along with its counterparts in Europe and Japan, as well as other countries, poured around $12 trillion into financial systems. They bought a variety of assets, and offered long-term loans for banks.

They are now facing breakout inflation, which is the most common fear. Morgan Stanley Analysts at NYSE recently calculated that the Fed, Bank of England and European Central Bank could see their portfolios shrink $2.2 trillion in the twelve months starting May. This is the peak of QE.

Graphic: The tide recedes – https://graphics.reuters.com/GLOBAL-ECONOMY/QT/movanbxnypa/chart.png

These estimates are only preliminary. The Fed may be more aggressive if it, like many analysts anticipate, shifts from letting mature securities expire to selling assets in order to accelerate the process.

It’s a moment of uniqueness. It is a unique moment.

The spillovers from removing central bank buyers who are important for setting global interest rates like U.S. Treasuries could be beneficial.

“We need a tightening of financial conditions…But it is possible we will see changes in rates or changes in the balance sheet that induce more of an effect on financial conditions than we think will happen,” said Karen Dynan during a presentation https://urldefense.com/v3/__https://www.piie.com/events/global-economic-prospects-spring-2022__;!!GFN0sa3rsbfR8OLyAw!I5PO5OHycXXyf5qSo3XRpPZMfLXxiHynFJaYt4mUyb6mLVGJFEheXYfUnNGa_dCoDdi1Q0nRKGk$ at the Peterson Institute for International Economics, where she is a senior fellow. QT can have negative effects on countries that are weaker and with higher levels of government debt. This could “cause an epidemic of sovereign debt crises across the globe” which will disrupt markets.

“VERY LITTLE EXPERIENCE WITH QT”

In sessions this week at the International Monetary Fund (World Bank) and International Monetary Fund, a series of interrelated problems dominates. This led to the IMF revealing last week that its global growth outlook would be cut for the second consecutive year.

Global commerce continues to be reshaped by the pandemic, with large parts of China’s economy under lockdown. The war in Ukraine is a human tragedy that has impacted flows of fuel, food, and industrial minerals around the world. Inflation is rising to unprecedented levels, which prompts central banks from developed countries to work together to stop it.

Graphic: Inflation becomes a common risk – https://graphics.reuters.com/GLOBAL-ECONOMY/CENBANKS/gkvlgazoqpb/chart.png

In order to reduce demand and lower prices, tighter monetar policy will be used, especially for credit-sensitive items such as homes and cars.

James Bullard, President of St. Louis Fed, stated earlier in the month that “a lot of the world’s inflation…certainly key producing regions such as Europe.” “We don’t want to feed the inflation process…Naturally many central banks pull back simultaneously. It is perfectly normal.

However, adding QT to increase interest rates is a risky proposition. Although economists and policymakers are aware of the overall impact, which is that interest rates would be higher than they were otherwise, the precise outcome remains uncertain.

“QT has very limited experience. Andrew Bailey, Bank of England Governor, stated in March that there is not enough experience with QT here.

BoE already allows its balance sheet to fall through passive methods: When bonds mature, rather than reinvesting their proceeds or maintaining cash levels in the financial sector, it deletes the money out of its account and the wider economic system. It reverses QE’s original money creation, and so the BoE’s deficit shrinks.

After raising its bank rate from 1.0%, the BoE stated that it would consider selling assets. The BoE expects a 25-basis point increase to 1% for investors on May 5.

So far, the ECB has not committed to halting net asset purchases until later in this year. Analysts expect that the ECB’s balance sheet will decrease if banks pay long-term loans. Some banks, like the Bank of Canada and others have already stopped investing.

Although the Bank of Japan has not yet tightened, it is slowing down asset purchases.

“RISK OF A MISTSTEP”

The Fed, by far the largest player in the market is likely to conclude its plans during a meeting that takes place in May. According to minutes of the March meeting, policymakers agreed to reduce their holdings by $95 billion per month and $1.1 trillion each year.

It all depends on the market reaction. Between 2017 and 2019, the Fed trimmed its balance sheets by approximately $650 million. This led to a shortfall in banking system reserves and spiked short-term rates. A quick reverse was necessary to quickly restore liquidity to the system.

Fed policymakers consider this a lesson learnt and they anticipate the process to go smoothly next time. However, it was a reminder that mistakes do happen.

Bond buying helps central banks to overcome low interest rates. This allows them to inject stimulus after they have cut policy rates to zero. This same logic allows them to withdraw support for economic growth faster than if they raise rates only. Adam Slater, Oxford Economics, estimates that major economies’ balance sheet cuts could increase the rate of interest by as much as 1.3%.

Graphic: Balance sheet tightening impact – https://graphics.reuters.com/GLOBAL-ECONOMY/QT/egvbkbzknpq/chart.png

Slater said that the new environment, which includes massive central bank operations to balance their books, means that tightening cycles in terms only of policy rates is not an accurate picture. We believe that the likelihood of an error in the coming one-to two years may be greater than ever since the 1980s.

What was the outcome? A vigorous fight against inflation led to a recession.