Monetary Policy – risk of disruption from QE tapering?

Since the time of the global financial crisis, central banks have bought large amounts of government bonds (and, to a lesser extent, private securities), thereby greatly expanding the size of their balance sheets

 The US Fed's balance sheet was almost USD 4.5 trillion by 2015, about five times its size before the crisis. The European Central Bank's (ECB) balance sheet has tripled and continues to expand. Markets have performed well during the period of balance-sheet expansion, and there are concerns that the Fed's shrinking of its balance sheet over the next year and a reduction of bond purchases by the ECB will cause a reversal.

Most likely, the unwinding of quantitative easing (QE) programmes will happen smoothly. Central banks have been very diligent in communicating their plans and have adopted a gradual approach. The Fed has already halted its asset purchases, and that has not sparked market turbulence (contrary to 2013, when a potential reduction of asset purchases was first communicated by the Fed and resulted in a surge in US yields).

The ECB's exit from QE may not proceed as smoothly. While the Fed's purchases of government debt were large in absolute terms, they were relatively modest compared to (high) net issuance of government debt, and resulted in modest portfolio shifts only. For example, during QE1 in 2009, other domestic and foreign buyers including banks and pension funds continued to purchase US government debt alongside the Fed. In contrast, the ECB's recent government bond purchases have been 3-4 times bigger than net issuance, and there has been significant reduction in the level of government bonds held by other investors. As such, when the ECB steps back as the dominant buyer, concerns about public debt sustainability may reduce private market appetite to purchase government bonds, leading to a sharp increase in sovereign yields. All said, the probability of such a scenario is considered fairly low. And in any case, the ECB would most likely resume its bond purchases in the event of financial market turbulence, mitigating any adverse impact.

Issuance and purchases of US/Euro area government bonds, 4-quarter sums in % GDP

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