The writer is Jerome and Dorothy Lemelson Professor of International Economics at MIT-Sloan School of Management and a former member of the monetary policy committee of the Bank of England
Central banks do not hesitate to expand their balance sheets when a crisis hits. They should also not hesitate to reduce their balance sheets during recoveries — especially when inflation is high.
In the past, the standard central bank playbook has been to wait for the recovery to solidify, then end any asset purchase programmes, then raise interest rates several times, and only then, if the recovery was still on track and inflation was nearing target, consider quantitative tightening.
The US was the only country to meet these criteria during the last recovery — but only two years after the first rate rise — and even then they could only unwind about $750bn of the $3.6tn purchased since 2006.
This approach may have made sense back then when inflation was low and the labour market slow to heal. If only a modest amount of tightening is needed, central banks should prioritise the tool that people understand and which can be better calibrated. And in an era of very low interest rates, it made sense to focus on raising rates.
But this time is different. There are several reasons why quantitative tightening should be a priority today. My focus here is on the US, although many of the arguments apply to other countries, such as Canada, the UK, New Zealand and Australia.
First, with inflation well above target, the output gap largely closed and above-trend growth likely to continue, the Federal Reserve will need to tighten monetary policy by quite a bit. Unlike the last recovery, there will be room to tighten using more than one tool. Quantitative tightening should not prevent interest rates from being raised several times.
Second, accomplishing some of the necessary tightening via the balance sheet could allow the Fed to raise interest rates more gradually. This would give vulnerable segments of the economy more time to prepare.
A year ago, market expectations were that the first rate rise would take place in April 2024. Now markets are expecting at least three such rises in 2022. And if inflation continues to exceed expectations, even more tightening may be needed.
Some households will not be ready for the higher cost of their credit card debt, and some small companies still struggling with the impact of the pandemic will not be ready for the higher cost of bank loans. Tightening via the balance sheet has less impact on short-term borrowing rates, giving these vulnerable sectors more time to prepare.
Third, tightening via the balance sheet would have a greater effect on the medium and longer end of the yield curve (which shows the different interest rates that investors demand for holding shorter and longer-dated government debt) and thereby more impact on the housing market. With house prices in the US hitting record highs, reducing stimulus for this sector could not only be manageable, but reduce the risk of a more painful adjustment later on. The Fed could also prioritise unwinding its $2.6tn of mortgage-backed securities faster than its Treasury holdings.
Finally, putting more emphasis on unwinding the balance sheet would be an important signal of central bank independence. It would confirm that quantitative easing is not permanent financing of fiscal deficits, and that asset purchases to support market liquidity (a key justification in early 2020) are not permanent support for markets.
This message is particularly important today after the massive interventions and expanded reach of central banks over the past two years. Additionally, a smaller balance sheet will reduce future losses when interest rates rise — losses that could undermine political support.
Although these are powerful reasons for central banks to make unwinding their balance sheets a priority, there are risks as well. This would be an important change in the central bank playbook, and therefore should be communicated in advance to the public to avoid provoking a sharp market adjustment that could undermine the recovery. Also, although recent research has improved our understanding of how QE works, we have no comparable metrics for the impact of quantitative tightening. Any unwinding should initially occur gradually so that we can learn about the magnitude of the effects.
After years of central banks worrying they had run out of tools, they currently have more policy levers at their disposal than at any time in history. Now is an opportune moment to use their balance sheets to fight inflation while supporting a balanced and sustainable recovery.