Finance 101: Quantitative Tightening

Fintoism Quantitative Tightening

The role of central banks in the global economy should never be underestimated. These financial institutions can apply a number of different monetary policies to sustain a domestic economy, including quantitative tightening and quantitative easing.

One of the options for central banks to explore is known as quantitative tightening, or QT.

The Concept of Quantitative Tightening

As the name suggests, a central bank performing this monetary policy is looking to create an adverse effect. Under normal circumstances, an economy has a certain amount of liquidity. Under very specific circumstances, a central bank can choose to increase or decrease that liquidity, depending on which course of action they see fit.

If the liquidity is decreased, quantitative tightening occurs. In most cases, this adverse effect will yield a positive outcome in other aspects of the economy. It is a method often applied to normalize or raise interest rates to avoid increasing inflation. 

When the inflation of any economy increases beyond what is considered normal, the prices for goods and services will begin to rise. It is then up to the central bank to increase the liquidity in the economy to offset this increase. Preventing such a development from taking place is always an advisable course of action.

No Major Implementation yet

Although quantitative tightening makes a lot of sense, it has never been utilized on a broad scale. More specifically, there have been some minor individual experiments with this approach. For now, central banks are still more intent on utilizing quantitative easing, rather than reducing overall liquidity. Given the current financial circumstances, it may not be all that long until that ship turns around.

One of the first big countries to implement this measure is the United States. Earlier in 2018, the Federal Reserve has retired some of the debt on its balance sheet. This is considered to be a first step toward embracing quantitative tightening even further.  It is expected that this practice will force prices of assets, goods, and services to either remain the same or start declining in the years to come. 

A Changing of the Guard

It will not be easy for central banks to move from quantitative easing to tightening in one go. Although the Federal Reserve is leading by example, it still has a long way to go. Right now, the central bank allows Treasury securities to mature without renewing them afterward. The next step is to retire mortgage-backed securities at an exponential rate.

While running off the Fed’s portfolio gradually is a start, the next course of action might not be taken right away. Until the central bank begins to sell securities out of its portfolio, the full impact of quantitative tightening will not be felt.  After all, the Federal Reserve doesn’t want to trigger any negative impact on the financial markets.

So far, other central banks have not shown any intention of utilizing QT in any capacity. Since it is the opposite process of what central banks are used to doing, that is not entirely surprising. Draining money from the financial system would make it even more difficult for financial institutions to make money and keep themselves afloat. 

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