END OF EASY MONEY BRINGS A $410 BILLION GLOBAL FINANCIAL SHOCK
Updated: May 25, 2022
The global shift away from easy money is poised to accelerate as a pandemic bond-buying blitz by central banks swings into reverse, threatening another shock to the world’s economies and financial markets.
Bloomberg Economics estimates that policy makers in the Group of Seven countries will shrink their balance sheets by about $410 billion in the remainder of 2022. It’s a stark turnaround from last year, when they added $2.8 trillion — taking the total expansion to more than $8 trillion since Covid-19 arrived.
That wave of monetary support helped prop up economies and asset prices through a pandemic slump. Central banks are pulling it back — belatedly, in the view of some critics — as inflation soars to multi-decade highs. The dual impact of shrinking balance sheets and higher interest rates adds up to an unprecedented challenge for a global economy already hit by Russia’s invasion of Ukraine and China’s new Covid lockdowns.
Unlike previous tightening cycles when the U.S. Federal Reserve was alone in shrinking its balance sheet, this time others are expected to do likewise.
Their new policy, known as quantitative tightening — the opposite of the quantitative easing that central banks turned to during the pandemic and the Great Recession — will likely send borrowing costs higher and dry up liquidity.
Already, rising bond yields, falling share prices and the stronger U.S. dollar are tightening financial conditions — even before the Fed’s push to raise interest rates gets into full swing.
“This is a major financial shock for the world,” said Alicia Garcia Herrero, chief economist for Asia Pacific at Natixis SA, who previously worked for the European Central Bank and International Monetary Fund. “You are already seeing the consequences of tapering in reduced dollar liquidity and dollar appreciation.”
The Fed is expected to raise rates by 50 basis points at its May 3 to 4 policy meeting and several times thereafter, with traders seeing about 250 basis points of tightening between now and year’s end. Officials are also expected to start trimming the balance sheet at a maximum pace of $95 billion a month, a quicker shift than most envisaged at the start of the year.
The U.S. central bank will achieve this by letting its holdings of government bonds and mortgage-backed securities mature, rather than actively selling the assets it bought. Policy makers have left open the option that they might, at a later stage, sell mortgage bonds and return to an all-Treasuries portfolio.
In 2013, the Fed’s balance-sheet plans caught investors by surprise and triggered an episode of financial turmoil that became known as the “taper tantrum.” This time around, the policy has been well telegraphed, in the U.S. and elsewhere. Asset managers have had time to price in the effects, which should make a wrenching shock on the markets less likely.
First in History
So far, the Fed’s proposed runoff has led investors to demand a cushion for risks of owning long-term U.S. Treasuries. Term premium — the extra compensation that investors require to own longer-maturity debt rather than continually rolling over shorter-dated obligations — has been on the rise.
Fed officials have said that QE helped depress yields by lowering term premium, providing a cushion for the economy during the 2020 recession.