Who's afraid of the big, bad balance sheet?

Posted by: Paul Donovan

22 Feb 2019

Quantitative policy is not new. The size of quantitative policy in recent years is new. And now quantitative policy is being reversed.

There are three ways a central bank can reverse quantitative policy.

  • Organic tightening: money demand grows faster than money supply. The Bank of England and the ECB are doing this.
  • Passive tightening: a central bank does not reinvest money from maturing bonds. The Federal Reserve's is doing this.
  • Aggressive tightening: the central bank sells bonds. This is unlikely to happen.

Quantitative easing did not create inflation. The increase in cash supply just matched an increase in cash demand. If falls in supply match falls in demand during quantitative tightening, the result is also inflation-neutral.

Economies are more cash-based than in the past. Thus central bank balance sheets should be larger. The amount of tightening required is smaller than the amount of past easing. Thus the impact of tightening on bond yields should be smaller than the impact of past easing.

The signal that tightening sends does matter. Quantitative easing was a powerful signal of lower for longer interest rates. Quantitative tightening is a weaker signal for interest rates. What central banks say when quantitative tightening may matter most to markets.

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