America 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 out 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 has been little or no assessment of risk.

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

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

A paper presented by New York University academics at the Jackson Hole conference of central bankers and central bank watchers in Wyoming last week addressed those questions. The paper questioned both the effectiveness of QE and the expectations that QT can be performed without adverse effects.

The paper looked at what happened to banks’ liquidity demands during QE and whether they were reduced during the previous QT episode.

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

QE is designed to compress long-term funding yields and encouraged longer-term bank lending, which could have happened to some extent.

Charging

However, the paper found that US banks did not take advantage of that compression, instead using the increase in reserves to shorten the maturity of their own loans, with QE’s maturity-shortening effect on banks’ liabilities offsetting the lengthening. of expiration. effects of QE or its assets.

In other words, the intended effects of QE were muted by the way commercial banks responded, indeed they may have been perverted by the response, with the shortening of the maturity of their liabilities making it more difficult for them to finance long-term loans and with less liquidity in the system than might have been suggested by higher reserve levels.

That led the researchers to wonder whether the banking sector, under QT, would reduce the claims it has written on liquidity — the deposits banks have taken and the lines of credit they have drawn — at the same rate that the central bank withdraws reserves. and suggest that this could lead to tighter liquidity conditions and a greater possibility of episodes of systemic liquidity stress.

Therefore, central banks should look for growing liquidity mismatches, they said, referring to banks’ behavior during QE and AT as “asymmetric behavior” that explains tighter liquidity conditions and occasional stress when QT is underway. .

There are various estimates of how much QT will affect interest rates. The Fed’s Jerome Powell has said that $1 trillion of QT was equivalent to a rate hike of around 25 basis points.

Other economists have estimated that two years of QT (Powell has said he expected QT to last between two and two and a half years), or a reduction of about $2.2 trillion in the Fed’s balance sheet, would be similar to a rate increase of between 29 and 74 basis points, depending on how volatile conditions were.
However, the amount of QT pushing up US rates (and global rates, given the influence the US Treasury market has on the rest of the world) is probably less consequential than the potential for unexpected shocks, with liquidity and asset market “events”. accidents are the most obvious.

The experience of 2019, when the complex and opaque pipelines of the US financial system ground to a halt, says that no one, including the Federal Reserve, can predict the potential unintended consequences. This episode of QT is, of course, much more aggressive than the one that led to the night markets crash in 2019.

While the Fed may not want to focus too much on its balance sheet, which grew from about $900 billion before the GFC to just over $4 trillion in the years after the GFC and then ballooned to $8.9 billion in response to the pandemic. , there is a view that it could destabilize the US government bond market, the cornerstone of global financial markets.

That market, according to those who trade in it, is already experiencing patchy liquidity. As the Federal Reserve reduces its balance sheet and market presence, the demands of private buyers will grow, increasing the potential for severe illiquidity and a dysfunctional market.

The 2019 scare came against a much more stable economic backdrop, without the runaway inflation, volatile geopolitics, and recessionary outlook of the current setup.

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

QE distorted all of the normal risk pricing that is critical to the effective functioning of markets as efficient allocators of capital without, as the Jackson Hole paper suggests, necessarily having the impacts it was supposed to.

After more than a decade of QE, and evidenced by the markets tantrum in 2018 and the liquidity freeze in 2019, investors’ conviction that central bankers would always rescue them from moral hazard entrenched in the financial system.

Charging

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

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