Quantitative Easing and Quantitative Tightening: A Quadruple-edged Sword

Quantitative Easing (QE) is an unconventional monetary policy tool that central banks deploy during economic downturns when conventional monetary policy, like lowering interest rates, proves insufficient. QE is a type of open market operation that involves large-scale purchase of government bonds and other financial assets, injects liquidity into the economy, lowers long-term interest rates, and stimulates borrowing and investment. This approach was first introduced in the United States in response to the 2008 financial crisis and has been reimplemented several times since, including during the COVID-19 pandemic (Cachanosky et al., 2021). While QE successfully stabilized financial markets in times of crisis, its  long-term implications — particularly inflationary pressures and challenges in reversing the policy — have raised significant concerns.

During the COVID-19 pandemic, the Federal Reserve took aggressive measures to counter economic fallout by lowering interest rates to near zero and significantly increasing asset purchases. These actions, which included large acquisitions of U.S. Treasury bonds and mortgage-backed securities (MBS), led the Fed's balance sheet to more than double “from about $4 trillion prior to the pandemic to nearly $9 trillion at the start of 2022"​ (Sablik, 2024). This influx of liquidity was crucial in keeping borrowing costs low, thus encouraging investment and spending. However, as the economy began to recover, the extensive liquidity injected into the financial system contributed to inflationary pressures, making it challenging for the Fed to manage price stability. The Fed’s use of QE, though effective in its immediate crisis response, presented longer-term risks, such as inflation control difficulties that continued beyond the initial economic recovery period ​(Sablik, 2024).

Quantitative Tightening (QT), the process of reversing QE by gradually shrinking the central bank's balance sheet, has had a more pronounced and lasting effect on bond yields than QE had in lowering them. Since the Fed began QT in 2022, the impact on bond yields has been stark. Estimates show that one month after a one-standard-deviation QT surprise during the asset runoff period, there was a cumulative 30 basis point increase in the two-year yield. In contrast, a one-standard-deviation QE surprise had an insignificant effect, with only a 5 basis point rise in the same yield (Lloyd & Ostry, 2024). This demonstrates how liquidity withdrawal under QT exerts far more upward pressure on short-term yields than liquidity injection during QE reduces them. This suggests not only QT’s ability to normalize interest rates rapidly but also its potential to trigger market instability if not carefully managed (Derby & Lawder, 2024). Even though the Fed implemented QT at a relatively slow pace — allowing $60 billion of Treasury and mortgage bonds to expire each month — the withdrawal of liquidity created challenges for financial markets that had become reliant on QE-driven liquidity (Derby & Lawder, 2024).

As the world’s largest economy, the United States’ use of QE and QT carries serious international consequences. U.S. QE exerts statistically and economically significant effects on emerging markets by appreciating local currencies, decreasing long-term bond yields by around 0.03%, and boosting stock prices by 1% (Bhattarai, Chatterjee & Park, 2021). These effects intensify over time, with peak impacts on exchange rates and stock prices reaching up to three times the initial effect approximately five months after the QE shock. Capital inflows into these markets increase by 2% at their peak, translating to about $3.9 billion overall or $300 million per country, leading to asset booms (Bhattarai, Chatterjee & Park, 2021). However, when the Fed hints at QT, such as during the 2013 tapering talks, these impacts reverse violently. Brazil’s currency depreciated by 12.52%, Turkey’s by 7.61%, and Indonesia’s external reserves fell by 13.61%. Stock indices dropped by 12.16% in Turkey and by 8.92% in Brazil, and bond yields surged in Indonesia by 64.75 basis points (Eichengreen & Gupta, 2015). These effects highlight how QT triggers capital outflows, currency depreciation, and financial instability, with particularly severe consequences for vulnerable economies. According to a panel study by Iacoviello and Navarro (2021) that analyzed 50 economies from 1965 to 2016, they found that a 100-basis-point monetary policy shock from the Fed caused a 0.5% decline in output for advanced economies and a 0.8% drop for developing countries after three years. Additionally, the authors constructed a vulnerability index with combined data on current account, foreign reserves, inflation, and external debt across 50 economies in which they found that the “GDP in more vulnerable economies falling much more in response to a U.S. monetary tightening”  (Iacoviello & Navarro, 2021).

In addition to its macroeconomic effects, QE has influenced corporate risk-taking behaviors. Hsu and Chen (2021) in their publication for the Bureau of Economic and Business Research found that firms with strong Corporate Social Responsibility (CSR) practices saw reduced default risks during QE periods. The authors examined 31,182 U.S. firm-year observations from 2000 to 2014 and discovered that QE helped firms with better CSR performance or financial distress by providing access to cheaper credit. However, the same liquidity that helped stabilize firms also led to excessive risk-taking in some sectors. Karadi and Nakov (2021) from the European Central Bank warned that QE could become "addictive" for financial markets. Their research found that QE’s flattening effect on the yield curve, by lowering long-term interest rates while keeping short-term rates low, reduced the margin between borrowing and lending rates, which is a key source of bank profitability. As a result, banks faced diminished profits, which slowed their ability to rebuild capital reserves. This weakened the banks' capacity to absorb future shocks or expand lending, which ultimately increased their reliance on QE-driven liquidity. The slower recapitalization also delayed the banking sector's return to normal financial operations, making it more vulnerable to potential instability once the Fed began withdrawing support through QT (Karadi & Nakov, 2021). 

In summary, while QE has proven to be a powerful tool in mitigating short-term economic crises, its use has also introduced significant inflationary pressures, distorted financial markets, and complicated global economic stability. The ongoing process of QT, led by the ever-cautious Jerome Powell, demonstrates the challenges that central banks face in withdrawing QE while trying to avoid triggering further market disruptions. 

Edited by Nicolas Nemati

References

Bhattarai, S., Chatterjee, A., & Park, W. Y. (2021). Effects of US quantitative easing on emerging market economies. Journal of Economic Dynamics and Control, 122, 104031.

Cachanosky, N., Cutsinger, B. P., Hogan, T. L., Luther, W. J., & Salter, A. W. (2021). The Federal Reserve's response to the COVID-19 contraction: An initial appraisal. Southern economic journal, 87(4), 1152–1174. https://doi.org/10.1002/soej.12498 

Derby, M. S., & Lawder, D. (2024). Fed's Powell says balance sheet drawdown continues amid rate cuts. Reuters. https://www.reuters.com/markets/us/feds-powell-says-balance-sheet-drawdown-continues-amid-rate-cuts-2024-09-18/

Eichengreen, B., & Gupta, P. (2015). Tapering talk: The impact of expectations of reduced Federal Reserve security purchases on emerging markets. Emerging Markets Review, 25, 1-15.

Hsu, F. J., & Chen, S. H. (2021). US quantitative easing and firm’s default risk:  The role of Corporate Social Responsibility (CSR). The Quarterly Review of Economics and Finance, 80, 650-664.

Iacoviello, M., & Navarro, G. (2019). Foreign effects of higher US interest rates. Journal of International Money and Finance, 95, 232-250.

Karadi, P., & Nakov, A. (2021). Effectiveness and addictiveness of quantitative easing. Journal of Monetary Economics, 117, 1096-1117.

Lloyd, S., & Ostry, D. (2024). The asymmetric effects of quantitative tightening and easing on financial markets. Economics Letters, 238, 111722.

Sablik, T. (2022). The Fed Is Shrinking Its Balance Sheet. What Does That Mean? Econ Focus, 27(3), 4–7. https://www.richmondfed.org/publications/research/econ_focus/2022/q3