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Differences between Quantitative Easing, Quantitative Tapering & Quantitative Tightening often confuse people.
We'll take a look at each, and the possible implications under each regime.
Quantitative Easing (QE)
QE = Central banks buying assets, primarily government bonds.
Different central banks have different rules on the exact assets they'll buy, although the main functions are the same:
Reduce interest rates and boost asset prices
How does it work? Here's the Bank Of England to explain:
We buy UK government bonds or corporate bonds from other financial companies and pension funds.
When we do this, the price of these bonds tend to increase which means that the bond yield, or ‘interest rate’ that holders of these bonds get, goes down.
The lower interest rate on UK government and corporate bonds then feeds through to lower interest rates on loans for households and businesses. That helps to boost spending in the economy and keep inflation at target.
QE also affects the prices of other assets like shares and property.
Here’s an example. Say we buy £1 million of government bonds from a pension fund. In place of those bonds, the pension fund now has £1 million in cash.
Rather than hold on to that cash, it will normally invest it in other financial assets, such as shares, that give it a higher return.
In turn, that tends to push up on the value of shares, making households and businesses holding those shares wealthier.
That makes them likely to spend more, boosting economic activity.
Another way to think of this is that the central bank reduces the amount of safe assets (sovereign bonds) in circulation by parking a load on their balance sheet, which also lowers the yield on those that remain in circulation.
This essentially forces any excess reserves into riskier investments (otherwise investment capital will generate low/zero returns).
QE is an asset swap, not 'money printing'
Which is where the Bank Of England explainer falls flat by saying 'cash' rather than 'reserves'... (Can't rely on them for anything).
Anyway, the mechanics of QE, asset swaps and regulations are mainly accounting and pretty boring.
However, there is one KEY distinction to make here. During the pandemic, the Federal Reserve directly financed immediate government spending.
This immediate transfer of 'cash' into consumer pockets via ready to spend stimulus payments is the type of money printing that can prove inflationary (and it did).
It's unlikely to be repeated at such a scale and isn't typically how QE works.
David Belle
Let's keep it simple and focus on the two main functions:
- Reduce interest rates
- Boost asset prices
QE definitely achieves both of those goals.
At some point, a central bank decides that the economy doesn't need as much support so...
Quantitative Tapering Begins...
This is commonly misunderstood.
Tapering doesn't mean the end of accommodative monetary policy.
Sometimes things like this are easier to understand with real-world examples:
Tim likes beer and kebabs. Loves getting "on it" with the lads.
But he's also a man of habit...
Four pints and a kebab religiously six nights a week.
Tim's getting fat now. Putting on 2 kilos every week.
So he decides to reduce (taper) his beer and kebab purchases.
But he's not ready to give them up completely.
He cuts it back to three nights a week.
He doesn't do any exercise, so he's still getting fatter.
Adding 1 kilo per week. Half the original pace.
Just like Tim's beer and kebabs, when central banks are tapering, they're still adding to the overall system/waistline, just at a slower pace than before.
Like Tim, The Federal Reserve have been gorging. Here's their projected balance sheet when this round of QE ends:
It won't quite make $9 trillion before QE4 ends, but I like the graphic (and round numbers) so it's staying.
Continuing the award-winning (soon) beer and kebab analogy, at this point Tim's decided he's cutting out beer & kebabs entirely (For central banks, no more QE).
We'll call this Quantitative Neutral.
No more asset purchases, but no actions to reduce the size of the balance sheet either. Just ticking along, reinvesting assets as they mature, maintaining the status quo.
In the parallel universe where Fat Tim is the central bank balance sheet, kebabs and beer are out, but there's no weight loss at all.
Time to start shedding a few of those excess pounds..
Quantitative Tightening (QT) Begins
Much like weight loss, there are two ways for central banks to approach this.
We'll label these as passive and active:
Passive Balance Sheet Reduction (QT Light)
Simply don't reinvest the assets as they mature. This is known as balance sheet runoff. Depending on the exact composition/maturity of the holdings, this is a relatively passive and slower way to reduce the balance sheet.
It's the equivalent of Tim going on a diet and not 'reinvesting' his biscuit consumption each day. Over time, that calorie deficit will see weight loss.
Active Balance Sheet Reduction (QT Proper)
The aggressive approach. Actively selling assets from the balance sheet and sucking liqudity out of the private sector.
This is when Tim gets serious about weight loss. He joins the gym, hires a nutritionist and trainer and starts researching clenbuterol cycles.
Serious business.
Why is QT generally bad for asset prices?
Because it decompresses the risk premium. The polar opposite of QE.
As the central bank QT program sucks liquidity from the system, there's a shrinking pool of capital that assets have to 'compete' for.
Government debt issuance plays a role too. Take the US treasury for example.
They need to issue debt so they can pay government employees, meet their budget commitments, pay social security etc. etc.
If the treasury are issuing (selling) debt at the same time as the Fed are selling debt, they're both taking liquidity from the private sector and reducing the pool of investable capital.
And for various regulatory reasons, the banking system 'has to' absorb the government issuance to ensure they meet their quota of High Quality Liquid Assets (HQLA).
All of which means there's less left over to chuck into fun things like memestonks and crypto.
Until the next time...
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David Belle
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