Central banks across the globe, including in the US, the UK and many European countries, have been hiking interest rates after every policy meeting to battle high inflation. The US Federal Reserve has been aggressive and has raised rates by more than 2 percentage points in just six months, while maintaining a hawkish stance and hinting at more rate hikes in the future.

In December 2021, Fed chairperson Jerome Powell admitted that inflation wasn’t transitory and hinted that the era of loose money was ending. Three months later in March 2022, it started hiking the rates. Some economists are calling the era of rate hikes or monetary policy normalisation quantitative tightening (QT). Let’s understand what it is and how it works.

What Is It?

• Central banks across the globe use various monetary actions and tools to control liquidity in the market. One of the tools that central banks use to control the supply of money in the economy is called QT.
• Through this tool, they reduce the balance sheet size by selling government bonds bought during quantitative easing (QE).
• QT leads to higher interest rates, which translates into higher borrowing cost and, finally, lower demand. It may, ultimately, lead to lower economic growth.

How Is It Different From QE?

• After the global financial crisis, major central banks such as the US Fed, the European Central Bank (ECB) and Bank of England used QE for the first time.
• It was done by lowering interest rates and purchasing government bonds to spur economic growth.
• QE continued worldwide from 2009-2017. This led to a massive increase in the balance sheet of central banks.
• From 2017 onwards, the Fed, ECB, and the Bank of Japan decided to reverse their monetary policy stance from QE to QT.

How Is It Done?

• QT is done mainly to tackle rising inflation. A central bank can control inflation by draining money from the financial system.
• When the central banks reduce bond purchases, other lenders fill in the vacuum as demand for sovereign bonds goes down.
• In case there are fewer or no new buyers, interest rates will need to be raised to make lending more attractive.
• It disincentivizes borrowing by increasing the cost, which in turn reduces the money supply.