Quantitative tightening is a monetary policy tool used by central banks to reduce the amount of money circulating in the economy. This tool is often implemented after a period of quantitative easing, where central banks inject money into the economy to stimulate growth.

During QE, central banks purchase government bonds and other financial assets to increase the money supply and lower interest rates, promoting borrowing and investment. QT is essentially the reverse of this process, aimed at tightening the money supply to prevent overheating in the economy and control inflation.

Goals of Quantitative Tightening

The main goals of QT are:

Controlling inflation: By reducing the money supply, QT helps to cool down an overheating economy and bring inflation under control.

Normalizing monetary policy: After extensive QE, QT aims to return the central bank’s balance sheet to a more typical size and composition.

How Does Quantitative Tightening Work?

Quantitative tightening involves several steps and mechanisms by which central banks reduce the money supply. Here’s how it typically works:

1. Ceasing purchases

The first step in QT is for the central bank to stop purchasing new securities. During QE periods, the central bank buys government bonds and other assets to inject money into the economy. In QT, these purchases are halted.

2. Allowing securities to mature

Central banks hold a variety of financial assets with fixed maturity dates. When these securities mature, the central bank has the option to reinvest the proceeds in new securities (to keep the balance sheet stable) or to stop reinvesting (to effectively remove money from circulation).

In QT, the central bank chooses not to reinvest these proceeds. Instead, it allows the securities to roll off its balance sheet, thereby reducing the money supply gradually.

3. Selling assets

In some cases, central banks may actively sell securities from their portfolios to accelerate the process of QT. By selling these assets, the central bank can more quickly reduce its balance sheet and the overall money supply.

4. Adjusting interest on reserves

Central banks can also use the interest rates paid on reserves as a tool for QT. By increasing the interest rates paid on the money that commercial banks hold at the central bank, commercial banks are more likely to keep their reserves rather than lend them out, which also reduces the money supply.