Quantitative Tightening
Quantitative tightening is the reduction of the balance sheet of a central bank, through the sale of assets or the cessation of reinvestment, undertaken to withdraw the liquidity that was injected during a period of quantitative easing. Quantitative tightening is the reverse of quantitative easing.
Concept
Quantitative easing expands the balance sheet of the central bank, through the purchase of assets, which injects liquidity into the financial system and lowers long-term interest rates. Quantitative tightening reduces the balance sheet, through the sale of assets or the run-off of maturing assets, which withdraws liquidity and raises long-term rates.
The two operations are the mirror image of each other, though the effects are not perfectly symmetric. The effects of tightening may differ from those of easing, since the conditions in the market and the behaviour of the participants may differ.
Mechanisms
Quantitative tightening operates through several channels. The reduction of the balance sheet withdraws reserves from the banking system, which may raise short-term rates if the reserves are scarce.
The sales of assets raise the supply of securities in the market, which may raise the yields and tighten the financial conditions. The reduction of the balance sheet also signals the intention of the central bank to normalise policy, which affects the expectations of the market.
The effect on the economy depends on the response of the financial conditions and on the state of the economy. A tightening that is undertaken when the economy is strong may have a limited effect, while a tightening that is undertaken when the economy is weak may have a larger effect.
Challenges
The use of quantitative tightening poses challenges. The effects of the reduction of the balance sheet are uncertain, since the experience is limited and the channels are not fully understood.
The reduction of the balance sheet may interact with the other instruments of policy, and the coordination between them is important. The central bank must manage the reduction without disrupting the market and without unnecessarily tightening the conditions.
The reduction also raises questions about the appropriate size of the balance sheet in the long run. The size determines the reserves in the banking system and the operating framework of the central bank.
The Normalisation of Policy
The normalisation of policy involves the gradual reduction of the balance sheet and the return of the policy rate to more normal levels. The process is managed carefully, to avoid disrupting the market and the economy.
The design of the normalisation affects the expectations of the market and the behaviour of the participants. The communication of the plans is therefore important, and it must be clear and consistent.
The experience with the normalisation is a subject of research, and it informs the understanding of the effects of the balance sheet policy and of the appropriate framework for the conduct of monetary policy.
The Balance Sheet of the Central Bank
The balance sheet of the central bank comprises the assets that it holds, including the government securities and the loans to the financial institutions, and the liabilities, including the currency in circulation and the reserves of the banks.
The quantitative easing expands the balance sheet, and the quantitative tightening reduces it. The size and the composition of the balance sheet affect the conditions in the financial markets and the transmission of the monetary policy.
The design of the balance sheet is a central element of the operating framework of the central bank. The framework determines the instruments that the central bank uses and the way in which it influences the interest rates.
The Effects on the Financial Markets
The quantitative tightening affects the financial markets through several channels. The reduction of the balance sheet withdraws the reserves and raises the supply of the securities, which tends to raise the yields and to tighten the financial conditions.
The effects depend on the response of the market and on the state of the economy. The market may anticipate the tightening, in which case the effect is already reflected in the prices. The tightening may also have the effects on the exchange rate and on the capital flows.
The analysis of the effects informs the design of the normalisation and the communication of the plans. The central bank must manage the reduction carefully to avoid the disruption of the market.
The Exit Strategy
The exit strategy from the unconventional policy involves the normalisation of the policy rate and the reduction of the balance sheet. The sequencing and the pace of the normalisation are central to the design.
The central bank may choose to raise the policy rate first and to reduce the balance sheet later, or to pursue the two in parallel. The choice depends on the conditions and on the framework of the policy.
The normalisation must be communicated clearly, and it must be adjusted as the conditions change. The credibility of the central bank is central to the success of the normalisation.
Summary
Quantitative tightening is the reduction of the balance sheet of the central bank, and it is the reverse of the quantitative easing. The analysis of the mechanisms, of the effects, and of the exit strategy informs the understanding of the balance sheet policy.