Over the last year the main central banks in the world have suddenly raised interest rates in order to curb the race of inflation whose level has become unsustainable both in Europe and in the United States. But not only that, the central banks have reduced some of their massive bond purchasesafter having flooded them with liquidity, in a market context in which borrowing costs were already zero.
However, now the scenario has changed and the question is: how much liquidity should the major central banks keep in the banking system in order to meet the demand (for reserves) now that monetary stimulus is no longer needed?
Changed market conditions
In the last decade, the main central banks, including the Fed and the ECB, have adopted unprecedented monetary stimulus policies, injecting a lot of liquidity to deal first with the 2008 financial crisis and then with the pandemic, an event that once again forced the main Central banks to intervene in support of the economy by purchasing additional securities at a sustained pace.
To deal with the recent financial and economic crises, in fact, one of the strategies most used by central banks is represented by Quantitative Easing (QE)an asset purchase program by central banks for increase liquidity and lower interest rates at the same time.
But as we said, after the pandemic the scenario has changed rapidly and the rapid post-pandemic economic recovery combined with the high and persistent level of growth in consumer prices is leading central banks to abandon the era of quantitative easing in favor of quantitative tightening , all in a context in which the tensions on prices to which the rises in interest rates are added.
So central banks are now outlining the trajectory of future monetary policy decisions, with many of them moving from monetary easing (QE) to quantitative tightening (QT), and process of reduction of reserves and money supply. But why do central banks want to phase out the economic support provided through QE?
With the QT the main central banks will reduce their balance sheet, thus also reducing the banks’ reserves and creating the space for new monetary policy actions.
Beginning of Quantitative Tightening
Here, from this point of view, as reported by an analyst to Reuters, the Fed and the ECB could remove up to 90% from the system of liquidity they have pumped into banks’ coffers over the last decade, indeed, now the combination of high inflation and rising interest rates make the extra liquidity unnecessary.
It is estimated that the Fed could thus reduce total reserves from the current $6 trillion to between $600 and $3.3 trillion, depending on whether it accepts US government bonds or less coveted assets in exchange.
Indeed, US Treasuries, like German government bonds, are rewarded on the market thanks to their liquidity and safety. This means that banks have less incentive to exchange them for deposits with the central bank.
The same path should be undertaken in the same way by the ECB which could, according to the analyst, reduce its liquidity supply from the current 4.1 trillion euros to just 521 billion euros, if it accepts only German government bonds , or about 1.4 trillion euros in the event that it also accepts other riskier ones.
However, neither scenario is entirely plausible and achievable in the short term and this is because both the Fed and the ECB have a mix of government bonds and other types of debt on their balance sheets.