How does QT work?

Nobody knows. But for the Eurozone it brings unique balance of payments challenges.

• No-one knows how QT will work—though we are about to find out;

• For the Eurozone, there are unique links between the Eurosystem balance sheet and the external accounts;

• QE brought portfolio outflows and partial other investment offsets both within and outside the Eurozone;

• QT will necessarily be associated with the return of non-resident portfolio investors as as well the reduction of TARGET2 claims across the Eurosystem—but the process is unlikely to be smooth.

Quantitative tightening (QT) has now been initiated by most major central banks—as contrasted here—with the European Central Bank (ECB) expected to join in balance sheet shrinkage through the Asset Purchase Program (APP) next year. Only the Bank of Japan remains a holdout amongst the major players, though this too could change.

In what follows, we discuss the links between the Eurosystem balance sheet and the balance of payments.

Before then, it’s worth emphasising how extraordinary our current situation is—as central banks undertake balance sheet shrinkage.

Consider the following:

• First, fiscal deficits are expanding in Europe. Over the past decade or so, post-GFC, quantitative easing (QE) was initiated into low or declining inflation alongside counter-cyclical fiscal deficits—in the US, UK, and Japan. Today, fiscal policy is expanding still due to the need to protect households and corporates from the energy crisis—in Europe at least. And so financing needs are growing into planned or expected central bank balance sheet contraction—including outright asset sales in the UK.

• Second, QT is now happening nearly everywhere at once. When it happened, QE was typically staggered—with the US and UK engaged early in the post-GFC decade, Japan from 2014 and the Eurozone from 2015. And while QE was coordinated during the pandemic, past balance sheet shrinkage, when it came, was small and uncoordinated. Instead, we are now entering a period of simultaneous balance sheet shrinkage by most major central banks.

• Third, the external accounts. Analysts seldom place balance sheet policy in the context of countries’ balance of payments financing needs. But the Eurozone and UK are facing exceptionally large external shocks due to the energy crisis—for the Eurozone that means moving from external surplus to deficit, from UK small to large external deficit. Balance sheet shrinkage into an expanding external financing need might be very different to such action when there is no such need—but no-one knows.

• Fourth, how does QT work? Remarkably, there is no consensus on how QT actually works. Indeed, there is a contradiction between the understanding of the major central banks. Contrast BOE with Fed. At the BOE it is claimed that QT can happen with little impact on the yield curve providing the path of Bank Rate is carefully communicated. In the US, by contrast, it is sometimes expressed that balance sheet shrinkage is an additional tightening tool for the Fed on top of fed funds rate.

• Fifth, related to this point, the reaction function of the major central banks is unclear at this moment—making the yield curve is jumpy. We are moving away from the ZLB, with inflation well above target and policy below what would be implied by a Taylor Rule type policy. But are we returning to the traditional Taylor Rule, with policy moving above neutral in the period ahead? Or something else?

• Finally, there are always hidden plumbing challenges when undertaking balance sheet reshuffling—as was discovered in the UK last week and potentially in the Eurozone periphery.

Despite these unknowns about how QT will work, we do know some things. In particular, we know that if APP reduction it is initiated in the Eurosystem it will require potentially large offsetting balance of payments portfolio debt flows, as is discussed in the remainder of this piece.