Quantitative Easing: the Beginning of the End

Fitch Ratings in its new report offers conclusions on the likely Quantitative Easing exit strategies of the Fed, European Central Bank (ECB), Bank of England (BOE) and Bank of Japan (BOJ).

Quantitative EasingAccording to Fitch Ratings report, fears of ‘mission creep’ will incentivise the major central banks to unwind Quantitative Easing (QE) over the next few years even if inflation remains low. The report offers conclusions on the likely QE exit strategies of the Fed, European Central Bank (ECB), Bank of England (BOE) and Bank of Japan (BOJ).

QE was a radical policy response to an exceptional set of macroeconomic risks. As those risks have diminished, so too has the justification for hugely elevated central bank balance sheets,” said Brian Coulton, Chief Economist at Fitch.

The broad objectives of QE – namely the avoidance of self-reinforcing deflation and the anchoring of inflation expectations in the face of the zero-lower bound on interest rates – have largely been achieved in the US and the UK and, increasingly, in the eurozone. The combination of above-trend growth, diminished economic slack and tight labour markets is making it harder to rationalise aggressive unconventional monetary policy stances on the basis of modest disappointments in hitting inflation targets.

The persistence of elevated central bank (CB) balance sheets beyond the horizons justified by the original objectives of QE would run the risk of ‘mission creep’, whereby CB balance sheets could start to be perceived as being beholden to fiscal objectives or to the comfort of financial markets. CBs are likely to want to resist these risks of fiscal and financial dominance. The increased risks to CB finances inherent in expanded balance sheets could also act as an incentive to unwind QE. Adverse shocks to CB finances have the potential to undermine CB independence and anti-inflation credibility.

The process of unwinding QE is, nevertheless, expected to be very slow. The Fed is expected to take five years to normalise its balance sheet and the ECB and BOE are not expected to start running down assets until 2020/2021. The BOJ’s balance sheet is expected to continue expanding through 2024, although the annual pace of asset purchases will likely be below the officially announced JPY80 trillion target from this year. A protracted global QE unwind is unlikely to have a large direct impact on the economy, as output gaps have closed and deleveraging pressures have eased, although it could generate communication challenges for CBs, as they will be using two tools – interest rate hikes and balance sheet reduction – to achieve a single target of withdrawing monetary policy stimulus.

However, the change in the net flow of CB asset purchases over the next few years will be profound. The four CBs have, in combination, been accumulating assets at an average annual rate of USD1,200 billion since 2009. We see this shrinking to around USD500 billion in 2018 and turning negative to over USD300 billion by 2020. There is strong empirical evidence that CBs – as huge, non-price-sensitive buyers – have compressed global bond yields in recent years and there are limited grounds for believing this effect will not be symmetric as they become net sellers. With government deficits persisting, the private sector will be called on to absorb a much larger supply of sovereign debt in the coming years, putting upward pressure on global bond yields. This could have broader implications, including for credit spreads and capital flows to emerging markets.