End of easy money brings with it a $410-billion global financial shock

Inflation is pushing central banks to shrink their balance sheets as they hike interest rates, adding a new risk for the world economy hit by war and lockdowns

The global shift away from easy money is poised to accelerate as a pandemic bond-buying blitz by central banks swings into reverse, threatening another shock to the world’s economies and financial markets.

Bloomberg Economics estimates that policy makers in the Group of Seven countries will shrink their balance sheets by about $410 billion in the remainder of 2022. It’s a stark turnaround from last year, when they added $2.8 trillion — taking the total expansion to more than $8 trillion since Covid-19 arrived.

That wave of monetary support helped prop up economies and asset prices through a pandemic slump. Central banks are pulling it back as inflation soars to multi-decade highs. The dual impact of shrinking balance sheets and higher interest rates adds up to an unprecedented challenge for a global economy already hit by Russia’s invasion of Ukraine and China’s new Covid lockdowns.

Unlike previous tightening cycles when the US Federal Reserve was alone in shrinking its balance sheet, this time others are expected to do likewise.

‘Major shock’

Their new policy, known as quantitative tightening (QT) — the opposite of the quantitative easing that central banks turned to during the pandemic and the Great Recession — will likely send borrowing costs higher and dry up liquidity. 

The Fed is expected to raise rates by 50 basis points at its May 3 to 4 policy meeting and several times thereafter, with traders seeing about 250 basis points of tightening between now and year’s end. Officials are also expected to start trimming the balance sheet at a maximum pace of $95 billion a month, a quicker shift than most envisaged at the start of the year. 

The US central bank will achieve this by letting its holdings of government bonds and mortgage-backed securities mature, rather than actively selling the assets it bought. In 2013, the Fed’s balance-sheet plans caught investors by surprise and triggered an episode of financial turmoil that became known as the “taper tantrum.” This time around, the policy has been well telegraphed, in the US and elsewhere. The Fed’s pace of balance sheet unwind is expected to be roughly twice as fast as in 2017, when it last ran down its holdings.  Others are moving in the same direction:  The European Central Bank has signalled it will end QE in the third quarter, a timeline that is complicated by the spillover from war in Ukraine.

The Bank of England has already started to shrink its balance sheet by ending gilt reinvestments in February. It is expected to hike rates again in May, bringing the key rate to the threshold where policy makers will weigh active sales from their asset portfolio.

The Bank of Canada’s passive roll-off of its balance sheet — opting not to buy new bonds when the ones it owns mature — is expected to see its holdings of government debt shrink by 40 per cent over the next two years.

The Bank of Japan is the standout and remains wedded to asset purchases — it had to scale them up in recent weeks to defend its policy of controlling bond yields. The yen has weakened to the lowest in 20 years in the process.

China, which avoided QE through the crisis, has switched to stimulus mode with targeted measures aimed at providing funding for smaller businesses.