The United States is about to embark on a risky experiment that could be destructive

We know from experience that QE inflated asset prices by encouraging investors to seek riskier assets in search of positive returns, with central banks effectively providing a safety net that defused higher risks. For much of the post-GFC period, there was little or no pricing of risk.

Will QT and the withdrawal of liquidity and this safety net work in the opposite direction, reintroducing risk premia and deflating asset prices? Will it be disruptive or, as former Fed Chair and now US Treasury Secretary Janet Yellen once said, like “watching the paint dry?” There are many points of view but little certainty.

QT offers some hope that over time markets will once again work as they are supposed to, hopefully without any of the destructive unintended consequences that some foresee.

A paper presented by New York University scholars at the Jackson Hole Conference of Central Bankers and Central Bank Observers in Wyoming last week tackled these questions. The article challenges both the effectiveness of QE and the expectation that QT can be performed without adverse effects.

The paper examines what happened to banks’ demands for liquidity during QE and whether they declined during the previous episode of QT.

With QE, when the Fed buys bonds or mortgages, it increases the amount of banks’ reserves, which they finance by borrowing from non-banks.

QE is designed to compress yields on long-term finance and encourage longer-term bank lending, which might have happened to some extent.

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The document however revealed that US banks did not benefit from this compression, instead using the increase in reserves to shorten the maturity of their own borrowing, with the maturity-shortening effect of QE on banks’ liabilities offsetting lengthening of maturity. effects of QE or their assets.

In other words, the desired effects of QE were mitigated by the way commercial banks reacted to it, or even may have been perverted by the response, as the shortening of the maturity of their liabilities made it more difficult for them to finance long-term loans and with less liquidity in the system than might have been suggested by the increased levels of reserves.

This has led researchers to wonder whether the banking industry would reduce, under QT, the claims it wrote on liquidity—the deposits banks took and the lines of credit they raised—at the same rate as the central bank withdraws its reserves. and suggest that this could lead to tighter liquidity conditions and a greater possibility of systemic liquidity crisis episodes.

Central banks should therefore look for growing liquidity asymmetries, they said, calling banks’ behavior during QE and TA “asymmetrical behavior” that explains the tightening of liquidity conditions and occasional strains when QT is In progress.

There are various estimates of QT’s impact on interest rates. The Fed’s Jerome Powell said $1 trillion of QT was equivalent to a rate hike of about 25 basis points.

The experience of 2019, when the complex and opaque plumbing of the US financial system seized up, indicates that no one, including the Fed, can predict the potential unintended consequences.Credit:PA

Other economists have estimated that two years of QT (Powell said he expects QT to last about two to two and a half years) is about a $2.2 trillion reduction in the balance sheet of the Fed, would amount to a rate hike of between 29 and 74 basis points, depending on how volatile conditions are.
The extent to which QT pushes up US rates (and global rates, given the influence of the US Treasury market on the rest of the world) is likely to have less consequence than the potential for unexpected impacts, however, with “ liquidity and asset market events. accidents being the most obvious.

The experience of 2019, when the complex and opaque plumbing of the US financial system seized up, indicates that no one, including the Fed, can predict the potential unintended consequences. This episode of QT is of course much more aggressive than the one that led to the day-to-day market crisis in 2019.

While the Fed may not want to focus too much on its balance sheet, which grew from around $900 billion before the GFC to just over $4 trillion in the post-GFC years and then exploded to $8.9 trillion in response to the pandemic, it is thought could destabilize the US government bond market, the lifeblood of global financial markets.

This market, according to those who trade there, already experiences uneven liquidity. As the Fed shrinks its balance sheet and market presence, demands on private buyers will increase, increasing the potential for severe illiquidity and market failure.

The scare of 2019 happened against a much more stable economic backdrop, without the runaway inflation, volatile geopolitics and recessionary prospect of current settings.

Longer term, if the Fed and its peers can release some of the more than US$12 trillion they have pumped into the financial system in response to the pandemic without markets convulsing, that would be a positive development. .

QE has distorted all of the normal pricing of risk that is fundamental to the efficient functioning of markets as efficient allocators of capital without, as the paper presented at Jackson Hole suggests, necessarily having the impacts it was intended to have. .

After more than a decade of quantitative easing – evidenced by the market tantrum in 2018 and the liquidity freeze in 2019 – investors’ belief that central bankers would always bail them out due to the moral hazard rooted in the financial system.

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QT offers some hope that over time markets will once again work as they are supposed to, hopefully without any of the destructive unintended consequences that some foresee.

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