The Economist July 10th 2021 pp65-67 |Finance & economics| “Quantitative Easing” “The quest to quit QE” “Central banks face up to the daunting task of shrinking their presence in financial markets”
Figure from https://www.clovaccocapital.com
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What is quantitative easing (QE)?
QE is the central bank buying its own treasury bonds with newly printed money (See Figure Above). As this happens the central bank takes on more debt but holds the bonds. QE has been a key part of coping with the economic fallout of the COVID pandemic. As of now Japan has about 40% of these bonds that are outstanding worth nearly 100% of their nominal GDP, Euro Area about 37% for about 25% of GDP, Britain about 30% for about 26% of GDP and America about 25% for about 20% of GDP.
With global economies coming out of the pandemic downturn most rich countries are now signalling that QE will be ending soon. The question is how will that tapering down of QE impact the bond prices, interest rates, equity markets and the economy in general. As it turns out many experts are struggling to quantify the effect of QE on bond prices. But ultimately, it is interest rate worries that fuel economic concerns.
Experts that have been surveyed “suggest that asset purchases worth 10% of GDP reduced the ten-year government bond yield by half a percentage point.” “Sky-high asset prices today reflect the assumption that long-term interest rates will stay low for a long time.” Looking back to what has been dubbed the 2013 tapering tantrum “asset prices fell because investors brought forward the date at which they expected the Fed to raise overnight interest rates, the traditional lever of monetary policy.”
In a way, tapering has already happened as the rate of purchases was high early in the pandemic at “almost $1.5trn in two months ” and then fell after two months to about $80bn per month. It is noted, at the time, there was not an expectation of higher interest rates as demand fell with waning business opportunities. Ultimately “the central banks’ balance-sheets influence long-term bond yield not directly...but by acting as a marker for future interest rates.”
Can central banks avoid a repeat of the 2013 tapering tantrum?
There are concerns that there could be a repeat of the 2013 tapering tantrum. A key concern is whether the central banks become so indebted that there’s no longer a rainy day fund. The banks must have enough reserve in normal times to step in during a crisis.
We are reminded that QE is really a tool to support the economy rather than financing emergency spending. QE puts more cash into circulation to faciltiate needed borrowing in hard economic times (See figure above).
Interestingly, QE can have the effect of lowering government borrowing costs by shifting costs to the central bank. However, it's important to realize that “central-bank reserves [are] created to buy bonds carrying a floating rate of interest making them analogous to short-term government borrowing.” This works well and is profitable for the Treasury unless interest rates rise. As interest rates rise the cost of that borrowing increases making “enormous balance-sheets.” Those more indebted balance sheets can result in losses that will have “consequences for the public finances.” This latter point especially emphasizes that governments cannot always "spend with abandon" through QE. (See figure below to understand bond supply and bond prices.)
Market for $100 1-year Treasury Notes. Figure from welkerswikinomics.com