Quantitative Tightening: Protecting Monetary Policy from Fiscal Encroachment

As we face up to the need to plan an eventual exit from quantitative easing, in this Commentary we consider how to reform both sides of the central bank balance sheet in a manner that will prepare the ground for a contraction in the balance sheet that does not expose the central bank to excessive risk. Post-QE central bank balance sheets have a maturity mismatch, with long term bonds as assets financed by liabilities in the form of commercial bank reserves bearing floating interest rates. In a central bank balance sheet contraction – quantitative tightening - the private sector will be asked to absorb those assets, which may place abrupt upward pressure on the yield curve. If policy interest rates rise, the interest cost of the central bank’s liabilities will rise quickly while the interest income from its assets rises only slowly. Prompt and timely moves to reduce the mis-match by reducing the duration of assets and increasing that of liabilities will limit both the financial risks to the central bank and the risk of disruption to bond markets.