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Coming QExit: Reversing Course

When it comes to monetary policy, the global financial crisis and Great Recession continue to cast a long shadow. Nine years on from the global financial system suffering the financial equivalent of a massive cardiac arrest, the four major developed world central banks--the U.S. Federal Reserve, the Bank of England (BoE), the Bank of Japan (BOJ), and the European Central Bank (ECB)--are all still doing quantitative easing (QE), either on a stock basis (the first two) or on both a flow and a stock basis (the latter two). How they will eventually unwind their stock of QE, and with what effects, has long been pondered, but up until now has been largely an academic question. With the Fed about to start to unwind its QE, this is all about to change, and raises a number of questions about the process. We try to answer them in the research paper 'QExit Q&A: Everything You Ever Wanted To Know About The Exit From Quantitative Easing', which can be downloaded at the end of this article.

What does QExit mean?

QExit is short-hand for “the exit from QE” (quantitative easing). It refers to the process whereby central banks that did QE in the past return—or shrink--their balance sheet to a normal or more normal level. Quantitative Easing is when a central bank attempts to ease monetary policy by expanding its balance sheet, acquiring assets financed by creating excess reserves. QExit reverses this process, returning the central bank’s balance sheet to its normal size (determined mainly by the public’s demand for banknotes and the amount of minimum required reserves).

Just as QE is a very mild form of monetary easing, the unwind of QE is a very mild form of monetary tightening. QExit is likely to be largely an innocuous process.

So QExit has nothing to do with Grexit and Brexit?

Grexit refers to the question of whether Greece was going to or will in the future leave—exit—the euro area. Brexit refers to the exit of the United Kingdom from the European Union. The process for this to happen is underway after the UK triggered Article 50 of the Treaty on the Functioning of the European Union on March 29 this year.

Why is this topic getting attention now?

In a word, the Fed. The Federal Reserve has been signaling for some time that it is getting close to starting the process of reducing the size of its balance sheet to more normal levels. After announcing after its June 13-14, 2017 FOMC (Federal Open Market Committee) meeting the details of how it intends to shrink its balance sheet, the Fed announced after its July 25-26, 2017 FOMC meeting that it expected to begin the process “relatively soon.” We expect the Fed to pull the trigger on the unwind process at its Sept. 19-20, 2017 FOMC meeting.

What is the right way to think about QExit?

QExit is just reversing QE, so the key to not getting bamboozled by the endless talk you are going to hear about QExit in coming years is to understand QE. The more you understand QE, the more you will understand QExit.

What is the right way to think about Quantitative Easing then?

QE is all about the central bank increasing the size of its balance sheet in order to ease monetary policy. Like any balance sheet, the Fed has assets on one side (the left-hand side) and liabilities and equity on the other side (the right-hand side), and has to obey the usual arithmetic of balance sheets. But a central bank is an altogether special entity, whose most fundamental job is to operate and regulate the monetary system of the economy. In the case of a privately owned, profit-seeking firm, the asset side of the balance sheet in a sense is primary and the liability side is secondary. In the case of a central bank, the liability side of the balance sheet is primary and the asset side is secondary: the central bank holds assets in order to supply money to the economy, not usually for their own sake, and on the liability side capital (equity) is the least significant of the major components.

QE is the process whereby the central bank purposefully expands the size of its balance sheet by acquiring assets financed by creating reserves (sometimes misleadingly termed “printing money”) with a view to easing financial conditions and thereby further stimulating economic activity.

The problem with this common way of characterizing QE is that it puts a one-sided focus on the size of the central bank’s balance sheet, conjuring up the image of runaway money printing (reserve creation) and stirring up (unfounded) fears of credit growth and later inflation exploding as part of a textbook money multiplier process. This has been the dog that didn’t bark in the almost nine years of this great monetary policy experiment.

There are several ways to understand how and why QE works, but they all revolve around the same basic fact: the central bank can alter the composition of assets in the hands of the private sector and by doing so disturb the existing asset price equilibrium. QE works through the “portfolio rebalance effect:” as investors rebalance their portfolios, asset prices return to (a new) equilibrium, easing financial conditions in the process. That all sounds quite technical, but it is the nub of the issue.

How do you apply the understanding of Quantitative Easing to understand QExit?

Simply reverse everything. In the same way that the central bank raising its target interest rate reverses its previous cuts, QExit involves reversing the expansion of the balance sheet that QE entailed. If QE eased financial conditions by disturbing the prevailing asset price equilibrium, then QExit tightens financial conditions by disturbing the newly prevailing asset price equilibrium in the other direction. If QE changed the composition of the private sector’s aggregate balance sheet by replacing government debt securities (and possibly other assets) with reserves and bank deposits, then QExit changes the composition back again, replacing reserves and bank deposits with government debt securities. If QE is just a debt financing operation of the consolidated government in one direction (treasuries to reserves), then QExit is just a debt financing operation of the consolidated government in the other direction (reserves to treasuries). If QE put downward pressure on the yield curve by taking duration out of the bond market and reducing the term premium, then QExit put upward pressure on the yield curve by returning duration to the bond market and increasing the term premium. If QE is a very weak form of monetary easing – which it manifestly is – then QExit must be a very weak form of monetary tightening.

How do the balance sheet mechanics of QExit work?

There are two ways, in principle, for a central bank to implement QExit: allow the balance sheet to shrink gradually as the assets it holds mature and “run off” the balance sheet; or shrink the balance sheet more actively by selling assets to the private sector. The Fed has announced that it will rely on run-off, selling assets only when the shrinkage of the balance sheet through run-off is insufficient to meet its pre-announced monthly targets for reducing the size of its balance sheet.

In the case of asset sales, the balance sheet mechanics are simpler and just reflect the central bank balance sheet identity (in change terms) analyzed above. Say the Fed were to sell $10 billion of the treasury securities it holds. Then the Fed’s balance sheet would shrink by $10 billion, that amount of reserves disappearing when the treasuries leave the balance sheet. Whoever bought those treasuries had to pay for them and the act of paying for them extinguished the reserves. Take the most simple case of a bank with an account at the Fed buying the treasuries. It paid the Fed for those treasuries by having its account at the Fed debited by $10 billion. The size of that bank’s balance sheet does not change, but its composition does, reserves going down by $10 billion and holdings of treasury securities going up by the same amount.

Does QExit imply a wall of new debt issuance by the government and raise the specter of a funding squeeze?

No, that is not the right way to think about it. Government debt securities do need to be refinanced during the unwind of QE. But, all the funding to refinance those government debt securities is already in place in the form of the reserves that were created when QE was implemented and that QExit aims to extinguish.

If Quantitative Easing was an exercise in rampant money printing, is QExit a process of money destruction, raising the specter of a credit crunch being triggered?

No, you can sleep easy on that front. Central banks do print money, physically (banknotes) and electronically (reserves), but they don’t print money in the way whose prospect alarms people, even when they do QE. The money printing that is potentially inflationary comes in two forms: governments running too-large budget deficits and banks lending too much.

Will QExit lead to longer term interest rates going up?

That should be the case. QE pushed down (nominal) interest rates along the yield and QExit should push them up. This follows from the reversal of the “portfolio rebalance effect” (the impact on asset price equilibrium from the central bank changing slightly the composition of the aggregate financial portfolio of the private sector) or, more specifically, the withdrawal of the downward pressure of QE on the term premium.

Will the QExit cause the QExit currency to appreciate?

There is nothing pre-determined about the way currencies move in response to economic, policy and other external developments, only theories and models that try to explain or predict how they should. All other things equal, economic theory predicts that monetary easing in a country will put downward pressure on the foreign exchange value of that country’s currency, and vice versa for monetary tightening. QExit is a form of monetary tightening, so a reasonable assumption is that, all other things equal, it will put upward pressure on the currencies concerned.

But things are never equal – there are always numerous things going on that impact foreign exchange markets. Take the analogy of the exchange rate of a country being like a buoy floating (untethered, of course) in the ocean. At any point in time the buoy will be subject to numerous cross-currents below the surface, that ebb and flow in strength, and as a net result the buoy will start bobbing around or drifting in a seemingly random fashion. Relative monetary policy settings represent one such cross-current, but it can easily be overpowered by others. And because the QExit process is set to unfold very gradually over several years, it represents quite a mild cross-current.

Won’t QExit trigger currency appreciation because part of the liquidity the central bank injected via Quantitative Easing had flowed into emerging markets and will now be withdrawn?

That is not the right way to think about it. When a central bank does QE, it creates reserves (a liability item on the central bank’s balance sheet, as distinct from foreign exchange reserves). These reserves, in aggregate, do not “flow” anywhere, least of all into foreign currency assets. They “sit” on the balance sheet of the central bank in domestic currency.

When QExit is completed, will the central bank’s balance sheet go back to the same size as when it started Quantitative Easing?

No. It will go back to its “normal” size not to its original (pre-QE) size. The reason is that the normal size of a central bank’s balance sheet increases gradually over time as the economy grows and the demand for credit and banknotes, which determine the main components of the central bank’s balance sheet, does as well (see earlier discussion).

Take the Fed as an example. At the time of the financial crisis, the Fed’s balance sheet was around $900 billion in size. Now it is about $4.47 trillion. If the Fed were to instantly unwind its QE today (an unrealistic thought experiment), it would reduce its balance sheet to around $1.83 trillion, roughly the sum of required reserves, banknotes, treasury deposits and capital. Given the Fed’s QExit is set to take several years, the normal size of its balance sheet is set to continue to grow in the interim, so when the Fed finishes unwinding its QE the size of its balance sheet will be considerably more than $1.83 trillion, more like $2.2 or $2.3 trillion, if things go according to the existing plan and the economy cooperates.

Do central banks need to unwind their Quantitative Easing?

Surprisingly, the answer is “not really”, even assuming that central banks stick to their mandates. It has become clear from the experience and experiments of the past few years, that central banks have two tools with which to operate monetary policy: the level of the (short-term) interest rate and the size (and composition) of the balance sheet. A central bank that wanted to ease monetary policy can either cut the interest rate (up to a point, not too deep in negative territory) or expand its balance sheet (pretty much without limit, other than legal ones). A central bank that wanted to tighten monetary policy can either raise the interest rate (there is no limit on how far) or shrink its balance sheet (back to a normal size, assuming it was extended to begin with).

If central banks don’t actually need to unwind their Quantitative Easing, why do they plan to do so?

The Fed is the only one of the major central banks that have done large-scale QE to have announced its QExit strategy. But, central banks being birds of a feather that tend to flock together, we can probably safely assume that when the other central banks get around to contemplating their QExits they will use the Fed’s approach as a template, particularly if it is seen to have worked.

To answer the question though, it is because central banks do not feel comfortable doing QE. Although the four major central banks, with various timings, have all been aggressive QE-ers, they have also been reluctant and uncomfortable QE-ers. The discomfort comes principally from the fact that QE, by its very nature, blurs the line between monetary and fiscal policy, as conventionally conceived, and, in the mind of the central bank and of many observers, threatens to compromise the “independence” of the central bank from the political sphere and from the imperatives of government finances.

How does the unwind of Quantitative Easing relate to negative interest rate policy?

There is no direct connection. As long as central banks are able to pay interest on reserves, they have two independent policy tools they can use: the short-term interest rate and the size and composition of the balance sheet. Several central banks have a negative policy interest rate and have done QE, notably the ECB and the BOJ. The main difference with the Fed is that these central banks pushed through the zero interest rate bound. The Fed could have done that too, but chose not to. When the ECB and the BOJ eventually get around to starting to unwind their QE, following the template of the Fed, they will probably start by raising their policy interest rates and taking them into positive territory before they start to shrink their balance sheets, but in principle they could do the reverse: maintain a negative policy rate while starting to shrink their balance sheets.

How is the Fed intending to implement its QExit?

The Fed announced in June this year its detailed plan for unwinding QE, after many years of referencing it in the minutes from FOMC discussions (dating back to April 2011) and earlier public communications about its balance sheet unwind thinking (notably the Policy Normalization Principles and Plans it released in September 2014 ). The plan involves two central planks: allow the balance sheet to shrink by regular pre-announced amounts, and begin small and build up to the maximum monthly amount of balance sheet shrinkage somewhat gradually.

Specifically, once the Fed raises the flag on QExit, it will reduce its holdings of treasury securities by $6 billion per month and its holdings of mortgage backed securities by $4 billion per month, increasing these amounts each quarter by $6 billion and $4 billion per month, respectively, until reaching a maximum monthly reduction amount of $30 billion and $20 billion per month, respectively (12 months after starting). This means that, if the amount of run-off from maturing securities is more than the targeted amount, the Fed would reinvest those proceeds, but if the amount was less the Fed would sell securities to make up the difference.

Does the Fed’s approach make sense?

Yes. Given the uncharted territory of QExit, it makes sense for the Fed to make the process as transparent and predictable as possible. The Fed wants to keep its and the market’s focus on the interest rate channel, which is much more familiar territory for all concerned. The Fed QExit plan sets up the balance sheet unwind as something that almost just runs in the background.

An interesting feature of the scheme is that the degree of quantitative tightening, although modest by virtue of how QE works, ratchets up each quarter for a year after the program begins. Given that the economy is getting closer and closer to full employment, but monetary policy works with a lag, one of the risks that the Fed must feel it faces is that it gets behind the curve, finding the economy hitting its speed limit at a time when monetary policy settings are still quite accommodative. The Fed may be taking out a bit of insurance against such an outcome by pre-programming a bit of escalation of quantitative tightening into the scheme.

How close are the other major central banks (the BoE, the ECB and the BOJ) to their QExits?

Not close at all, although the Bank of England is arguably the closest. For central banks doing QE, for the process of QExit to begin, first the central bank has to stop doing QE on a flow basis. Even then, it is likely to be a considerable time before the central bank starts the QExit process.The Fed stopped expanding its balance sheet in October 2014 and is only now on the cusp of entering QExit territory.

Both the ECB and the BOJ, on the other hand, are still in full-fledged balance sheet expansion mode, albeit doing QE in quite different ways.