Central banks must shrink their balance sheets more aggressively
The author is Jerome and Dorothy Lemelson Professor of International Economics, MIT Sloan School of Management, and former member of the Bank of England’s Monetary Policy Committee
When a crisis hits, central banks don’t hesitate to expand their balance sheets. They should also not hesitate to shrink their balance sheets during the recovery — especially when inflation is high.
In the past, the standard practice for central banks was to wait for the recovery to consolidate, then end any asset purchase programs, then hike rates multiple times, and only then consider quantitative tightening if the recovery is still on track and inflation is near target.
During the last recovery, the US was the only country that met these criteria — but only two years away from raising rates for the first time — and even then they were only able to withdraw about $750 billion from the $3.6 trillion bought since 2006 Dollar.
This approach may have made sense at a time when inflation was low and labor markets were slow to recover. If only modest tightening is required, central banks should prioritize tools that people understand and can better calibrate. In an era of very low interest rates, it makes sense to focus on raising them.
But this time is different. There are several reasons why quantitative tightening should be a priority today. My focus is on the US, although many of the arguments apply to other countries such as Canada, UK, New Zealand and Australia.
First, with inflation well above target and the output gap largely narrowing and likely to continue growing above trend, the Fed will need to tighten monetary policy substantially. Unlike the last recovery, using more than one tool will have room to tighten. Quantitative tightening should not prevent multiple rate hikes.
Second, accomplishing some necessary tightening through the balance sheet would allow the Fed to raise interest rates more slowly. This will give vulnerable sectors of the economy more time to prepare.
A year ago, markets expected the first rate hike to take place in April 2024. Markets now expect at least three rate hikes in 2022. If inflation continues to exceed expectations, further policy tightening may be needed.
Some households won’t be prepared for the higher cost of credit card debt, while some small businesses still struggling with the impact of the pandemic won’t be prepared for the higher cost of bank loans. Tighter balance sheets have less of an impact on short-term borrowing rates, giving these vulnerable industries more time to prepare.
Third, through a tightening of the balance sheet, there will be a greater impact on the mid- and long-term ends of the yield curve (suggesting that investors have different requirements for holding short- and long-term government bonds), and thus the housing market. With U.S. home prices hitting record highs, reducing stimulus to the industry will not only keep it under control, but also reduce the risk of a more painful adjustment later. The Fed could also prioritize unwinding its $260 million in mortgage-backed securities at a faster pace than its holdings of U.S. Treasuries.
Finally, a greater emphasis on shrinking the balance sheet will be an important signal of central bank independence. It will confirm that QE is not a permanent financing of fiscal deficits and that asset purchases to support market liquidity (a key rationale in early 2020) are not a permanent support for markets.
This message is especially relevant today, following the massive central bank intervention and expansion of influence over the past two years. Also, when interest rates rise, a smaller balance sheet would reduce future losses — losses that could dent political support.
While these are strong reasons for central banks to make cleaning their balance sheets a priority, there are also risks. This would be an important change in central bank strategy and should be communicated to the public in advance to avoid triggering a drastic market correction that could derail the recovery. Furthermore, while recent research has improved our understanding of how QE works, we do not have comparable metrics to measure the impact of QT. Any liquidation should initially happen gradually so that we can understand the magnitude of the impact.
For years, central banks have worried that they have run out of tools, but they now have more policy leverage than at any time in history. Now is a good time to use the balance sheet to fight inflation while supporting a balanced and sustainable recovery.