As inflation concerns continue to grip economies worldwide, European central banks are exploring the possibility of accelerating the process of shrinking their vast bond portfolios. Quants experts and economists argue that this move would not only reinforce the fight against inflation but it would also create room for purchasing assets in times of future crises.

Adopting quantitative tighening

Rate rises have been the primary tool adopted by central banks to tackle the recent surge in inflation. Both the US Federal Reserve and the European Central Bank (ECB) are possibly expected to raise interest rates again, with the Bank of England following suit, However, central banks have also adopted a strategy known as quantitative tightening (QT), involving the reduction of bond holdings to shrink their balance sheets.

According to data analysis by the Financial Times, the ECB and Bank of England still hold more than a quarter of their governments’ outstanding debt, while the US Federal Reserve holds around a fifth. The QT process, initiated last year, has so far unfolded relatively smoothly. During this time there were a few signs of disruption in bond markets. Nevertheless the success? of this approach has raised the confidence of economists and senior central bank officials.? Discussions followed about the potential of accelerating the strategy especially in Europe.

Mark Wall, chief economist at Deutsche Bank, believes that it would be reasonable for the ECB to consider gradually unwinding its expanded balance sheets. He suggests that this could serve as a strategy to reinforce the credibility of further rate hikes. Paul Hollingsworth, chief European economist at BNP Paribas, indicated that while an immediate decision is not expected, more ECB members might consider accepting a lower terminal rate if it allows for an accelerated QT process.

Tomasz Wieladek, chief European economist for fixed income at T Rowe Price, views QT as a means of curbing demand in the economy. He suggests that central banks do not often openly discuss QT due to the fine line it treads between monetary and fiscal policy. However, if utilized more forcefully as an instrument, it could effectively control inflationary pressures.

Selling bonds before they mature

The possibility??of actively selling some bonds before their maturity was a topic of discussion at the ECB’s annual conference in Sintra, Portugal last month.

German central bank head, Joachim Nagel, has previously hinted at a faster shrinkage of a separate €1.7 trillion? bond-buying programme launched in response to the pandemic. Jens Eisenschmidt, chief Europe economist at Morgan Stanley, predicts that the ECB could begin shrinking the purchase program early next year and completely halt reinvestments by July, resulting in a reduction of €133 billion in 2024.

While some central banks are contemplating the acceleration of QT, others, such as the US Federal Reserve, have shown no signs of planning to adjust their current approach. The Fed remains cautious about liquidity levels in financial markets and is mindful of the lessons learned in 2019 when it was forced to halt QT after a $750 billion reduction in its asset holdings led to a spike in short-term funding costs.

Praveen Korapaty, chief global rates strategist at Goldman Sachs, suggests that the Fed could proceed with QT this year and into 2024 without any significant issues, given the current level of liquidity in the financial system. However, he highlights concerns about an uneven distribution of bank reserves, with certain institutions facing more immediate pressures than others.

Quantative over-tightning could be detrimental

Despite the potential benefits of accelerating QT, analysts caution against over-tightening financial conditions. The recent collapse of several lenders, including Silicon Valley Bank, serves as a warning, indicating the need for central banks to exercise prudence.

Tomasz Wieladek, Chief European Economist at T. Rowe Price,? argues that stepping up QT could help rebalance the distributional impacts of monetary policy tightening. While policy rates remain the primary instrument, he contends that relying solely on this tool could disproportionately impact certain actors in the economy, such as mortgage holders.

However, the QT process is not without risks. As it is relatively uncharted territory for many major central banks, there are also a number of uncertainties, and the consequences of QT may be non-linear. There is a possibility that the cost of government borrowing could suddenly rise significantly, posing further challenges for monetary policymakers.

Ashok Bhatia, IMF director in Europe, views the current approach as appropriate, with room for periodic reassessments of the pace of QT in the future. As central banks continue to navigate the complexities of monetary policy amid inflationary pressures, their decisions on QT will play a crucial role in shaping economic stability and growth in the years to come.

The impact on forex markets could be significant, with a direct impact on interest rates and liquidity levels. However, central banks are cautious and remain open to periodic reassessments of the pace of QT to ensure the stability of the global financial system.

 

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