The last decade of monetary policy was defined by quantitative easing (QE). This was designed by the Federal Reserve and other central banks to stimulate the economy in a zero-interest rate world.
The mechanics of this effort entailed central banks buying up assets such as Treasuries, mortgage-backed securities (MBS), corporate bonds, and stocks, in some instances. By buying up these assets and essentially removing them from the economy, central banks were increasing liquidity in the system. Central bank intervention particularly around the Covid-19 pandemic is credited with saving a major market collapse and thus preventing a deep and prolonged recession. QE certainly had a very material impact on risk appetites which do have an inadvertent effect on the economy through the 'wealth effect'. Holding interest rates at emergency levels as well as the overall impact of financial repression has in many ways forced investors into risk assets and propelled their valuations.
Now, the situation is much different as persistent inflation is the economy's major threat. The obvious tool to combat this is to raise rates which the Fed is moving towards. But this has a drawback in that it would slow the economy. The Federal Reserve, like most other developed nation central banks, has a dual mandate - boosting employment and stable prices measured by inflation at a longer-term average of 2%. Of course, there is somewhat of a trade-off between these 2 goals in that fighting inflation has the collateral effect of slowing the economy and reducing employment.
But the Federal Reserve major balance sheet expansion of recent years has also enabled it to potentially unlock another tool for the central bank which is quantitative tightening (QT) or the inverse of QE. Quantitative Tightening is when the central bank receives principal repayments from its Treasury holdings but does not roll them over into newly issued Treasuries. Instead, the Federal Reserve takes the proceeds and simply cancels them. The reserves disappear from the banking system with a few keyboard strokes just as they appeared with a few strokes during QE.
QT means the Federal Reserve would reduce its balance sheet by selling assets and in effect, removing liquidity from the system. Just like QE had a stimulatory effect on the "financial economy" whilst having a mild effect on the "real economy", it is perhaps likely that QT would have a dampening effect on the "financial economy". This would potentially provide a silver bullet for the Federal Reserve – pulling down inflation without hurting or “choking-off” real economic growth.
QT has been deployed once before – 2017 to 2019, albeit for a limited period and in an overall limited fashion. The market impacts were captured in what was called the “taper tantrum” when equities displayed higher levels of volatility and bond yields rose. It may be different this time, with carefully choreographed forward guidance and communication it could be Fed’ Chair Jerome Powell is the man to deliver this new central banking strategy with aplomb? QE is still underway, so QT is not on the immediate horizon. The Federal Reserve is currently tapering the pace of its monthly bond purchases, which until November were running at $120 billion a month. The purchases are scheduled to end in mid-March. Last time around, the Federal Reserve did not turn to quantitative tightening until it had raised its interest rate target range from near zero to 1-1.25%. Of course, there are no guarantees, Federal Reserve Chair Powell has been clear that Balance sheet reduction is not to start until rate rises are in motion. The sequence of events is perhaps likely to be: tapering, rate hikes, and then QT. The speed could be much faster this time, however. Goldman Sachs is pencilling in a start to QT in the fourth quarter of this calendar year although we believe an earlier start in the third quarter is not out of the question.
In terms of market implications, we have already seen some significant stock and sector rotations. Smaller and medium-sized growth stocks with weak or even zero profits are vulnerable and sensitive to fluctuations of liquidity in such an environment. Bond yields probably have further north to travel. At the same time, it should benefit more value-oriented and cyclical stocks which are more tied to the real economy.