What happens when $2 trillion is sucked out of the global economy? It may not be pretty

London CNN

The central banks are credited for preventing a global recession twice in the last 15 years. Once, after the financial crisis of 2008, and then again during the peak of the Coronavirus pandemic.

The tactics they used to restore confidence and to keep money flowing out of banks into the economy were a high-stakes gamble -- one that could be difficult to undo without destabilizing financial systems.

The central banks bought government bonds, other assets and assets worth tens or hundreds of trillions in an effort to lower borrowing costs over the long-term and stimulate their economies. The 'quantitative ease', or QE measure, led to a flood in cheap cash, and gave policymakers a newfound power over the markets. Investors dubbed it the "era of easy money."

Since inflation reached its highest level for a generation in the past year, central bankers have undertaken a quest to shrink their bulging balance sheets. They are selling securities and letting them mature so that they disappear from their books. According to Fitch Ratings, 'quantitative tightening' (QT) by the top central banks is expected to drain $2 trillion of liquidity from the financial system in the next two-years.

This kind of liquidity drain could put additional strain on the markets and banking system, already struggling with high interest rates and nervous investors.

Raghuramrajan, former governor of Reserve Bank of India who spoke at the gathering of central banks in Jackson Hole Wyoming last year, expressed concern that we were in uncharted waters. He said that QT would likely have 'unintended effects'.

Swollen balance sheets

According to Fitch, between 2009 and 2022 the US Federal Reserve and other central banks, including the Bank of England and the European Central Bank, purchased long-dated assets and bonds, such as mortgage-backed security, totaling a staggering $19.7 trillion.

As the central banks of the world, with the exception of the Bank of Japan, continue to shrink their balance sheets it is impossible to predict what will happen when more liquidity is removed from the financial sector.

Janet Yellen compared QT in 2017 to 'watching the paint dry', describing it as a process that runs quietly behind the scenes. Rajan, a professor of Finance at the University of Chicago disagrees. He noted that investors and banks adjust their strategies according to the amount in the financial system.

The problem with QE is that it becomes an addiction.

Investors dumped US government bonds and stock after the Fed announced that it would reduce its pace of asset purchases for 2013.

When the central bank used QT to shrink its balance sheet from 2017 to 2019, it caused problems on some markets. In September 2019 for instance, the US overnight loan market -- where banks borrow money quickly and inexpensively for short periods of time -- unexpectedly seized up. The Fed was forced to inject emergency liquidity.

Gary Richardson is an economist at the University of California Irvine. He says that there's "a lot of uncertainty" as the period of very easy money' comes to an end and a new phase begins.

Signs of strain

According to experts, the destabilizing effect of QT is evident in two episodes involving acute market stress that occurred over the last eight months.

The sharp fall in gilts in the UK last September, which caused the pound to crash and forced the Bank of England into action repeatedly, was partly triggered by concerns about Liz Truss's plans to increase borrowing by the government just as the Bank of England prepared to begin selling public debt. Investors expected that an excess of gilts would lower their value.

Fitch analysts stated in their report that the crisis "showed a risk of disorderly dynamic" in government bond market during QT, and should serve as an "awakening."

Rajan stated that QT also contributes to the turmoil in the US banking industry, by exposing weaker actors like Silicon Valley Bank which failed in march. The banks saw deposits explode during the easy money era, accumulating liabilities that were far in excess of the amounts insured by federal government. Central banks began withdrawing liquidity from financial systems. This creates a potentially dangerous mismatch if depositors demand their money suddenly.

Even worse, central banks are simultaneously raising interest rates. This has left large holes in the balance sheets of many banks. The higher interest rates have reduced the value of many bank investments, such as long-term government securities that were once considered safe.

Rajan has always said, "Don't do QT until you have your interest rates in line." Doing both at once makes the situation more complex and can cause problems.

What can happen?

To minimize disruption, central bankers claim they are taking a gradual approach and making it predictable.

Dave Ramsden testified to the UK Parliament on Thursday. He said, "We've tried to set out signs on the road map."

Jennifer McKeown of Capital Economics noted in a client note this week that the bond market appeared to be more sensitive to rate hikes over the last year than QT. She wrote that the impact of QT has been modest so far.

But markets are still fragile. Yet markets remain fragile.

The September crisis in Britain also demonstrated that investors weren't the sole ones at risk from QT. Politicians must also take into account the paradigm shift that is underway.

Central banks have been willing to purchase large amounts of government debt, which has helped lower the cost of servicing it. Governments must now find new buyers to fund green investments or digitalization measures.

Richardson, at the University of California Irvine, believes that the new approach of central bankers may become a major cause of friction in the United States even if the debate over the nation's national debt ceiling is settled.

He said that if our central bank does not buy all of these bonds then interest rates on debt will be much higher. At some point, the Fed will have to deal with politics.