What is quantitative tightening and how does it work? To understand quantitative tightening, it is first important to understand quantitative easing. In the wake of the global financial crisis of 2007-09, investors and politicians got used to the idea of quantitative easing, a new twist on monetary policy. Quantitative easing, also known as QE, is defined as a form of monetary policy in which a central bank purchases securities on the open market to reduce interest rates and increase the money supply in order to stimulate economic growth. In other words, central banks use QE to expand their balance-sheets, creating money in the form of bank reserves to buy government bonds and other assets from the private sector. The principal aim of quantitative easing is to reduce the cost of borrowing money over the long term, particularly in the bond market. This monetary policy has been used in America from 2009 until 2022.
The Federal Reserve started raising interest rates in March 2022 to stymie soaring inflation. But the national bank has been doing something to control price growth: quantitative tightening, also known as QT. Indeed, quantitative tightening is the very opposite of quantitative easing. It is a monetary policy used to contract or reduce the Fed’s balance sheet. In other words, the Fed shrinks its monetary reserves by either selling government bonds or letting them mature and removing them from its cash balances. This process removes money from financial markets and the economy in general.
One of the objectives of the Federal Reserve is to keep the general level of prices stable. Inflation indicates that prices are far above their conventional level, which makes the cost of goods and services more expensive and the purchasing power losing its value. Thus, to tame inflation and bring back the prices to their conventional levels, the Federal Reserve increases interest rates. How does the Fed increase interest rates? By selling bonds, which pushes prices down of long-term securities, and raises their yield. When the Federal Reserve sells government bonds, it increases the cost of borrowing, which makes it more expensive to take out loans. Thus, this reduced demand and push inflation down.
Inflation has, indeed, been consistently declining since the Federal Reserve increased interest rates. Between March 2022 and May 2023, the Federal Reserve raised rates ten times. During that period, it became much harder for investors, corporations, financial institutions, and wealthy individuals to take out loans for future investments. It became difficult for corporations to raise capital to grow their operations. Indeed, the easy days of meme stocks going to the moon are long gone as corporations can no longer rely on cheap money for growth. The recent rate hikes will make it even harder for corporations to grow, and for investors to take on debt. Thus, the pace of investment will continue to decline. As stocks are very sensitive to bearish investor sentiment, the expected future return of a particular business cycle are dismal, and even though investors are conditioned to volatility, a withdrawal of liquidity from markets can trigger a crisis in the stock market. For the bond market, bond prices are expected to decline and their yield to increase.
When can we expect the Fed to stop using QT? When Chairman Powell thinks he’ll have squeezed the credit market enough.