By Tommy Wilkes

LONDON, (Reuters) – As the speculation about the Federal Reserve’s future plans to reduce its balance sheets grows, analysts believe that the era “quantitative tightening”, as it is known, has already begun.

Although central banks’ balance sheets grew after the Pandemic of 2020, and with economies recovering and inflation above target, they are now preparing markets to reverse their bond-buying stimulus.

Below is a collection of graphic that illustrates the impact of central banks’ stimulus on society and shows what may happen in future.

STOP, THEN SHRINK

The prospect that the Fed would raise interest rates in March and then implement quantitative tightening — which is a reduction of the Fed’s $8.8 trillion balance after its size doubled during the pandemic — caused markets to tumble this month.

The European Central Bank and other central banks are expected to continue adding global liquidity to offset some of the tightening.

This means that, while central bank liquidity pools have been expanding slowly since mid-2021 it is unlikely there will be a complete reduction in balance sheets until 2022 or 2023.

(Graphic: Global central bank stimulus – https://fingfx.thomsonreuters.com/gfx/mkt/gdpzykbekvw/cbank%20sheet.JPG)

BofA strategists anticipate major central bank balance sheets will stabilise in 2022 rather than shrink, but as a percent of GDP they believe the major banks will experience a decline relative to 2021.

Steve Donzé, senior macro strategist at Pictet Asset Management, estimates the Fed, ECB, Bank of Japan, Bank of England, People’s Bank of China and the Swiss National Bank will collectively expand their balance sheets by $600 billion in 2022 — far below the post-financial crisis average of $1.8 trillion and 2021’s $2.6 trillion, but still a net addition.

But he warns that the Fed’s $600billion forecast may be out of reach if it tightens quicker than is anticipated.

A stronger dollar also meant global investors that the five largest central banks took in more stimulus during the three months ending December than the previous three months. This was the first quarter-on–quarter drop since the pandemic.

(Graphic: Central bank liquidity flows-https://fingfx.thomsonreuters.com/gfx/mkt/klvykqbawvg/pictet%20global%20liquidity.PNG)

Donzé reckons Fed tightening, driven by the end of quantitative easing, rate hikes and then QT, will result in a 4.7 percentage point rise in a U.S. “shadow” real policy rate to -1.8% by the end of 2022.

The shadow rate rose six percentage points in the most recent tightening cycle. However, that was more than five years ago, from 2014 to 2019.

FLOWS NOT LEVELS

Many observers believe that, despite the fact that central banks have balance sheets exceedingly large of $25 trillion, rates will continue to be historically low and liquidity will not be tightened.

(Graphic: Central bank balance sheets, total assets – https://fingfx.thomsonreuters.com/gfx/mkt/akvezexqwpr/cenbank%20balance%20sheets.PNG)

For markets that are flooded with cheap cash, it is the direction of travel which matters.

Inflation-adjusted negative bond yields may suggest that the party will go on, but Citi’s Matt King says central bank stimulus flows have fallen fast and “markets do not follow levels, they flow”.

JP Morgan strategists note that excessive money supply, the ratio of money demand to gross money supply, has fallen by one measure since May. This year’s decline in excess liquidity is expected to be even more rapid.

(Graphic: Excess money supply – https://fingfx.thomsonreuters.com/gfx/mkt/jnpwejbmlpw/jpm%20money%20supply%20chart.PNG)

The researchers also calculated that the money supply will fall from $7.5 trillion annually in 2021 to $4.5 trillion and $3 trillion respectively in 2022, a pace last seen in 2010.