Quantitative Easing and Tightening: Balance-Sheet Mechanics, the Portfolio-Balance Channel and Run-Off

What you will learn

• What happens on central bank and bank balance sheets when bonds are bought with new reserves.
• The channels through which quantitative easing (QE) affects yields.
• How quantitative tightening (QT) works.
• Why QT is not simply QE in reverse.

Explanation

The mechanics of a purchase

Quantitative easing (QE) is the large-scale purchase of bonds (government and, in some programmes, covered, corporate or mortgage bonds) paid for with newly created reserves. Suppose the central bank buys a €100 million bond from a pension fund that banks at Bank A:

• Central bank: assets +€100m (bond); liabilities +€100m (Bank A's reserves).
• Bank A: assets +€100m (reserves); liabilities +€100m (the fund's deposit).
• Pension fund: a bond becomes a deposit; total unchanged.

Reserves rise one-for-one with purchases (hence the floor systems of lesson 2), bank balance sheets grow although banks did nothing, and the private sector holds less duration and more cash than it wanted.

Why it affects yields

• Signalling channel: purchases signal that the policy rate will stay low for a long time; expected short rates fall, and with them longer yields.
• Portfolio-balance channel: investors who sold bonds rebalance into other assets, pushing up prices of longer bonds, corporate bonds and equities. QE thus lowers the term premium, the extra yield demanded for holding long maturities. The duration removed, not just the euro amount, is what matters.
• Liquidity channel: in a crisis, a reliable buyer stops fire sales (March 2020).

Studies estimate the effect on 10-year yields at tens of basis points per programme, but estimates vary widely; treat any single number with caution.

Quantitative tightening

Quantitative tightening (QT) reduces those holdings by one of three methods:

1. Passive run-off: maturing bonds are not replaced. The ECB stopped reinvesting its asset purchase programme (APP) in mid-2023 and its pandemic programme (PEPP) at the end of 2024; since 2025 its portfolios shrink as bonds mature.
2. Capped run-off: only a monthly maximum rolls off; the rest is reinvested. The Fed started in June 2022 with caps that reached $60 billion for Treasuries and $35 billion for mortgage-backed securities per month, slowed the pace in 2024 and 2025, and ended run-off on 1 December 2025, after total assets had fallen by over $2 trillion from the roughly $9 trillion peak.
3. Active sales: the Bank of England has also sold gilts outright (lesson 8).

When a bond matures, the government repays it from its account at the central bank, and reserves fall by the same amount. QT therefore drains reserves until they approach the level banks consider "ample". The Fed stopped in 2025 because repo rates had begun to rise relative to IORB, an early sign that reserves were no longer abundant.

Why QT is not QE in reverse

• QE is announced loudly and front-loaded; QT runs quietly on a schedule, so its market effect per euro is usually smaller.
• Bonds were bought at low yields; as rates rose, central banks paid more interest on reserves than they earned. The Bundesbank and the Fed, among others, reported losses or deferred assets in 2023–2024. Such losses reduce transfers to governments; they do not stop a central bank from operating.
• Private investors must absorb the supply the central bank no longer buys, so the term premium can rise.

Worked example

Hypothetical example: all figures invented.

Part 1: duration removed by QE. A central bank buys €40 billion of bonds per month for 12 months: €40bn × 12 = €480 billion, average modified duration 7 years. The price sensitivity removed from private hands, as value change per basis point (DV01, bonds course), is €480,000,000,000 × 7 × 0.0001 = €336 million per basis point. If the eligible bond stock is €2,400 billion, the programme absorbs 480 ÷ 2,400 = 20% of the market in one year.

Part 2: capped run-off. Later the bank starts QT with a €15 billion monthly cap. In a month in which €30 billion matures, €15 billion rolls off and €15 billion is reinvested. If this repeats every month, the balance sheet shrinks by €15bn × 12 = €180 billion per year, and the €480 billion from Part 1 takes 32 months to unwind. In a month with only €10 billion maturing, run-off is €10 billion; the unused cap is not carried forward.

Exclusions: coupon reinvestment, other asset classes and new government issuance.

Common mistake

Practice activity

On paper: a central bank runs QT with a monthly cap of €15 billion. Hypothetical maturities over six months: €20bn, €10bn, €35bn, €15bn, €25bn, €5bn. (a) Calculate the run-off each month and in total. (b) How much is reinvested? (c) If reserves were €3,000 billion and nothing else changed, what are they after six months?

Key takeaways

• Every euro of QE creates one euro of reserves and of bank deposits; the private sector gives up duration.
• QE works through signalling, portfolio balance (lower term premium) and liquidity, not by giving money to households.
• QT runs through run-off, capped run-off or active sales; caps make the pace predictable and slow.
• QT drains reserves until they stop being abundant; rising repo rates relative to the floor are the warning sign.

Next step

Next we read the weekly central bank balance sheet line by line, including TLTROs, repo and reverse repo.