The author is the Jerome and Dorothy Lemelson Professor of International Economics at MIT-Sloan School of Management and a former member of the Bank of England’s Monetary Policy Committee
Central banks do not hesitate to expand their balance sheets when a crisis hits. Nor should they hesitate to reduce their balance sheets during the recovery – especially when inflation is high.
In the past, the usual playbook of central banks has been to wait for the recovery to firm, then end all asset purchase programs, then raise interest rates several times, and only do so when the recovery is still on track and inflation is catching up Target approached, consider quantitative tightening.
The US was the only country to meet those criteria during the most recent recovery – but only two years after the first rate hike – and even then it was only able to unwind about $750 billion of the $3.6 trillion acquired since 2006.
This approach may have made sense at a time when inflation was low and the labor market was slow to recover. If only minor tightening is needed, central banks should prioritize the tool that people understand and that can be better calibrated. And in times of very low interest rates, it made sense to focus on rate hikes.
But this time it’s different. There are several reasons why quantitative tightening should be a priority today. My focus here is on the US, although many of the arguments apply to other countries such as Canada, the UK, New Zealand and Australia.
First, the US Federal Reserve will need to tighten significantly as inflation is well above target, the output gap is broadly closed and growth should remain above trend. Unlike the last restoration, there’s room for tightening with more than one tool. Quantitative tightening should not prevent interest rates from being hiked several times.
Second, some of the necessary balance sheet tightening could allow the Fed to raise interest rates more gradually. This would give vulnerable segments of the economy more time to prepare.
A year ago, market expectations were that the first rate hike would take place in April 2024. Now markets are expecting at least three such increases in 2022. And if inflation continues to beat expectations, even more tightening may be needed.
Some households won’t be ready for the higher cost of their credit card debt, and some small businesses still grappling with the impact of the pandemic won’t be ready for the higher cost of bank borrowing. Tightening across the balance sheet has less of an impact on short-term interest rates, giving these vulnerable sectors more time to prepare.
Third, tightening across the balance sheet would have a greater impact on the middle and longer ends of the yield curve (which shows the different interest rates investors charge for holding shorter and longer government bonds), and therefore a greater impact on the real estate market. With US home prices hitting record highs, reducing stimulus to the sector could not only be doable but also reduce the risk of a more painful adjustment down the road. The Fed may also prioritize unwinding its $2.6 trillion in mortgage-backed securities faster than its Treasury holdings.
Finally, a stronger emphasis on balance sheet repair would be an important signal of central bank independence. It would confirm that quantitative easing is not permanent funding of fiscal deficits and that buying assets to support market liquidity (a key rationale in early 2020) is not permanent support for markets.
This message is particularly relevant today after the massive interventions and expanded reach of central banks over the past two years. In addition, a smaller balance sheet will reduce future losses when interest rates rise — losses that could undermine political support.
While these are important reasons for central banks to make winding down their balance sheets a priority, there are also risks. This would be an important change in the central bank’s playbook and should therefore be communicated to the public in advance to avoid provoking a sharp market adjustment that could undermine the recovery. While recent research has improved our understanding of how QE works, we do not have comparable metrics for the impact of quantitative tightening. The unwinding should be done gradually at first so that we can see the magnitude of the impact.
After years of fearing they were running out of tools, central banks now have more policy leverage at their disposal than at any time in history. Now is an opportune moment to use their balance sheets to fight inflation while supporting a balanced and sustainable recovery.
