London, May 20 (IANS): The worlds most influential central banks -- apart from the Bank of Japan -- are steadily reducing the size of their balance sheets, and no one knows for sure what will happen as more and more liquidity is withdrawn from the financial system.
Since inflation hit its highest level in a generation last year, central banks have embarked on the quest -- unprecedented in scale -- of shrinking their bloated balance sheets by selling securities or letting them mature and disappear from their books, CNN reported.
"Quantitative tightening," or QT, by top central banks will suck $2 trillion in liquidity out of the financial system over the next two years, according to a recent analysis by Fitch Ratings.
A liquidity drain of that magnitude could amplify strains on the banking system and markets, which are already grappling with a sharp run-up in interest rates and edgy investors.
"There are concerns we are in uncharted territory," said Raghuram Rajan, the former governor of the Reserve Bank of India (RBI), who presented a paper on these risks at last year's gathering of central bankers in Jackson Hole, Wyoming.
He noted that "unintended consequences" were likely as QT continued, CNN reported.
Between 2009 and 2022, purchases of long-dated government bonds and assets such as mortgage-backed securities by the US Federal Reserve, the Bank of England, the European Central Bank and the Bank of Japan totaled an eye-watering $19.7 trillion, according to Fitch.
In 2017, Janet Yellen compared QT to "watching paint dry," describing the process as "something that runs quietly in the background".
Rajan, now a professor of finance at the University of Chicago, disagrees. Investors and banks calibrate their strategies to the amount of money in the financial system, he noted.
"The problem is this demand for liquidity ratchets up, and it's very hard to wean the system off it," Rajan told CNN, likening QE to an "addiction."
A mere indication from the Fed that it intended to reduce the pace of its asset purchases in 2013 led to the so-called "taper tantrum," with investors dumping US government bonds and stocks, CNN reported.
And when the central bank tried QT, shrinking the size of its balance sheet between 2017 and 2019, trouble soon followed in some markets. In September 2019, for example, the US overnight lending market — which banks use to quickly and cheaply borrow money for short periods — seized up unexpectedly. The Fed had to intervene with an emergency infusion of liquidity.
Ultimately, "there's a lot of uncertainty" as a period of "very easy money" ends and a new chapter begins, according to Gary Richardson, an economics professor at the University of California, Irvine, CNN reported.
The destabilizing effects of QT are evident in two episodes of acute market stress over the past eight months, according to some experts.
A sharp selloff in UK government bonds, or gilts, last September -- which crashed the pound and required the Bank of England to step in repeatedly -- was triggered in part by fears about plans by former Prime Minister Liz Truss to increase government borrowing just as the Bank of England was about to start selling public debt.
Investors anticipated that an oversupply of gilts would depress their value.
The crisis "showed the risk of disorderly dynamics" in government bond markets during QT and should serve as a "wake-up call", Fitch analysts said in their report, CNN reported.