The Bank of Englands new version of unconventional monetary policy actually begins in earnest

Back in February of this year I wrote an article on a new type of unconventional monetary policy by the Bank of England. It was not something that the media reported widely or well. Indeed many places seemed to ignore it completely. This was slightly confusing to me as the original version of Quantitative Easing had been reported almost ad infinitum in the media and the press. It was potentially a significant change in the  monetary policy that the Bank of England was operating in my view and as I shall discuss later likely to be a good change. However for some time the policy has remained dormant and barely used. On Tuesday this changed somewhat and the Bank of England began to operate its new system. In my opinion these reasons for this change were intertwined but from the same route. The first is that market volatility and a decline in appetite for taking risks meant that the Bank of England was keen to begin implementing its new tool and the second was that for the same reason market players were willing to accept the terms offered by the Bank. 

What happened on February 4th 2010? 

The Chancellor Alastair Darling wrote to the Bank of England and gave it the following instructions and authorisation.The letter authorised the Bank of England to spend up to £50 billion on asset purchases. However these would now be private sector assets as opposed to the public sector ones that the Bank of England’s Quantitative Easing programme had mostly ended up purchasing. It will buy commercial paper,corporate bonds and secured commercial bonds with the money and it will be financed by the issue of Treasury Bills. So just to make it clear whilst the Bank of England will no longer buy government bonds it will continue to buy corporate bonds under this programme. 

How is this different from Quantitative Easing?   

1. It will be paid for by the issue of Treasury Bills and not the Bank of England creating money. 

2. It will purchase private sector assets as described above. 

Implications of such a policy 

I wrote on this subject on the 5th February and my views on it still hold 

Actually on a first reading this policy looks preferable to the Quantitative Easing policy which had previously been pursued. This is more in line with the way the US Federal Reserve has operated and as I wrote yesterday it has had more success than we have had with unconventional monetary operations so far. So hopefully companies will find it easier and cheaper to finance long-term borrowings. This does seem to have been the American experience. Also borrowing the money and not simply creating it is a better more transparent system as I never liked the idea of circulating money between the Bank of England and the Treasury.We should have done more of this and less of  QE. If we had our economy would be in better shape now.For the curious the average rate paid on 3 month Treasury Bills in January was 0.49% according to the Bank of England. 

The only drawback is that some of these private-sector markets are quite small in the UK so it may take a while to spend the money and have an impact. So far the Bank of England has only spent some £479 million on Commercial Paper and £1,484 million on Corporate Bonds. It bought £2.11 million yesterday so at that rate it would take quite some time to spend £50 billion! 

After welcoming the policy I went on to point out that there was one potential flaw in it. 

Having had time to think a little more about this policy it still looks a good idea to me. One flaw that does come to mind is the adage for banks ” be careful of borrowing short and loaning long”. In principle this can apply to nations too and in borrowing on a rolling 3 month timescale and loaning to bonds which have much longer lifespans e.g 5 years,10 years this is exactly what we are doing. 

What has happened since February? 

Well until Tuesday the truth is not much. I speculated at the time that there appeared to be some friction between the Bank of England and the UK Treasury. You see the announcement of this was released on the HM Treasury website in the evening and not with the normal monthly Bank of England monetary policy announcement,which had been earlier that day. It certainly was not good policy procedure in my view and smacked of political opportunism and possible disagreements between the Chancellor and the Treasury. I got the feeling that maybe the Bank of England was not very keen on this policy and tried to put it on the back-burner for some reason. 

The change on Tuesday 25th May 

The Bank of England bought £88 million of Corporate Bonds, just to give a comparison it only bought some £12 million in the whole of the previous week. This is quite an acceleration because up until that time it had only bought £109 million of Corporate Bonds using this system according to its website. So perhaps we are seeing a change. 

What good might this policy do? 

1. The clearest link is that such purchases by the Bank of England should reduce interest rates in the corporate bond markets should help companies to borrow more cheaply. This has clear potential benefits for the UK economy. 

2. The second issue is that of volume. You see the UK has one of the smaller Corporate Bond sectors in comparison with its Gross Domestic Product of the developed world. As a ratio of our GDP the UK stands at 0.16 which compares with an average of 0.53 and for example the United States on 1.30, Italy on 0.60,France on 0.57, Germany on 0.36 and Japan on 0.38. These figures are from 2008 and are from the World Bank Financial Sector Dataset. 

So there are two potential gains here. The encouragement provided by the Bank of England being a backstop may help and develop the Corporate Bond market. This in itself is a good objective but of course currently with bank lending still constrained and limited is particularly important as we try to recover from the follow-on effects of the credit crunch. As banks are rumoured not be lending to each other in the inter-bank market they are unlikely to be rushing to lend to commercial borrowers! 

Conclusion 

This policy is in my view superior to the original Quantitative Easing policy of the Bank of England. Rather than purchasing our own debt and hoping for good effects from it (which in my view have headed more towards asset price bubbles and inflation) we purchase corporate debt and make it cheaper for companies to borrow. There may be a follow-on effect of increasing the size of the corporate bond and commercial paper markets. Both are good objectives and I have been surprised that the Bank of England has not followed this policy with more enthusiasm. Perhaps of course it might embarrass the £200 billion they spent on Quantitative Easing! 

Also the letter from the Chancellor did have in my view one other side effect. As regular readers will know I think that there was and indeed is not much left of the concept of Bank of England independence and this put another nail in its coffin. 

Spanish banking sector developments 

After discussing and analysing the Spanish banking sector and indeed her economy on Monday there have been some further developments. There has been some criticism of Spain’s financial position by the International Monetary Fund and even rumours of another downgrade. Anyway the Bank of Spain has produced some potential reforms. 

1. In future all non performing loans will be fully provisioned for within a year rather than the current timetable of up to 6 years. 

2.The Bank of Spain will change its position that all non performing loans have to be covered 100% and will allow for offsetting from the value of the asset. This might seem a reduction but is an improvement as you see the 100% provisioning rule has led Spanish banks to make all sorts of financial contortions to avoid having to provision because the current rate is so penal. 

3. There will be increased provisions on acquired assets. The amount of provisions on recovered or acquired real estate assets will rise to 30% if these assets are held for more than 2 years. 

Of these the third is the most significant as Nomura has produced some research which indicates that the cajas or savings banks have not provisioned to this level. Further it has looked at the level of real estate assets compared with the cajas equity and seven of them have more real estate assets than equity with three estimated as having twice as much. Of these Cajasur (which I discussed in detail on Monday) was way out in front at 411% so it is probably for best that it is in the hands of the Bank of Spain. 

On slightly different tack as Nomura feel that the Spanish banks have a better level of provisioning for non performing loans BBVA has struggled to renew 1 billion Euros of commercial paper funding in US markets. With the current problems in inter-bank markets this may make it more dependent on funding from the European Central Bank (ECB). It is not entirely reassuring that the main users of ECB funding have been the Greek banks… 

Conclusion 

I believe that strains in the Spanish banking system and beginning to show and the cajas or savings banks in particular are showing more and more signs of the strain. It is not clear to me that the policy of mergers really solves things as a bad debt is not fixed by it and a relatively good caja is weakened in the process. The policy strikes me as something of a gamble on good fortune. 

I was asked recently to give an opinion about Santander which has expanded its operations in the UK over the course of the credit crunch and my thoughts remain as they were on the 5th February. 

When we went into crisis it appeared that the Spanish banking system had operated under a superior regulatory regime when compared with ours and was accordingly in better health. So from an apparent position of strength Santander (a Spanish bank) was able to buy Abbey, Alliance and Leicester and some of Bradford and Bingley making it a major player in UK banking. It published what on the face of them were solid figures this week. But with the severe problems in its domestic economy I cannot help but have the feeling that there must be underlying strains there. The unemployment rate in Spain and the housing crisis must be hurting the Spanish banking sector. 

Now I do not want to ratchet up fears at a nervous time ….. Also Santander has a prudent reputation. However if the distress in Spain rises and it does hit problems then there are clear implications for the UK. Should we have allowed it to expand so much in the UK? I had the feeling at the time that as the only buyer in our crisis we were letting Santander over expand in the UK. 

I wish to emphasise that I have nothing against Spain or Spanish banks making investments in the UK. In many respects I welcome this, but I feel that we let Santander expand too much here particularly considering that it was obvious even then that the Spanish property market was very over-extended which had in the end to hurt her banking sector. I feel that our authorities were so desperate for a short-term “saviour” they closed their eyes to potential and indeed the likely long-term implications of this.

Update 11.35 am

Spain has passed her austerity budget through her Parliament but according to Reuters the vote was 169-168 so literally by the skin of its teeth. This indicates that there are a lot of objections to this package in Spain and I suspect this story will run and run.

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5 thoughts on “The Bank of Englands new version of unconventional monetary policy actually begins in earnest

  1. Shaun, it is indeed good to see that you appear to be expressing greater conviction now that the BoE sham of indepedence is exactly that! “As regular readers will know I think that there was and indeed is not much left of the concept of Bank of England independence and this put another nail in its coffin.”

    It seems on a wider note that almost all Central Banks have gone or are going the same way, to gradually lose any independence from political tinkering and control which they may have once had, e.g. now also the ECB. This surely takes us back to the conflict between Capitalism and Socialism where it is intermixed in political control and governance? This toxic mix cannot and does not work, since it is like mixing oil and water. Politicians thus take back control of Central banks so as to force Socialism to appear to work by giving them the ability to debauch their currencies; but this in reality only buys them time, and temporarily avoids the necessary economic correction.

    As I have observed previously, try as one might, ultimately it is impossible to divorce politics from economics; this is because politics is really about an attempt to distort economic realities, so as to achieve political ideologies.

    • Hi Drf
      One irony of the credit crunch is that the Central Bank that went into it being considered the least independent the Bank of Japan is on its way to becoming the most independent. Not only have the other main central banks lost some or all of their independence but the Bank of Japan is engaged in what is an unseemly row (at least in Japanese terms) with the Japanese government. So one has to say its independence has increased somewhat although how long the Japanese monetary authority can blame the fiscal authority and vice versa is a moot point for Japan.

  2. Drf:

    Is there any practical difference between pure capitalism and pure socialism.

    The logical end of pure capitalism is a single global company which controls everything. That company would use no end of dirty tricks to stamp out smaller more efficient rivals.

    The logical end of pure socialism is a single global department which controls everything. That department would use no end of dirty tricks to stamp out smaller more efficient rivals.

    I’m not a great fan of purity.

    On another note, I believe that one of the great unintended consequences of central bank independence and stable interest rates was the growth of debt mountain and asset bubbles. The lack of stability that government interference tends to create pricks bubbles earlier.

    • Hi Jonathan, I understand what you mean about the logical ends of Capitalism and of Socialism, but I would differ with you slightly as to what they are.

      The logical (proven) end of Socialism is economic collapse, and we saw a good model of this in the USSR. (We may be about to see something similar in China, with industrial unrest and clamours for higher wages and a welfare state, which could result in a similar scenario to that which occurred in the USSR.) This is because the intrinsic relationship between Socialism and economics is an antipathy. Socialism requires unlimited scarce resources, which do not exist.

      The logical end of unrestrained Capitalism is monopoly. That is principally why all practical models of so called Capitalism have introduced Anti-Trust or anti-monopoly legislation and regulation to limit monopoly. All of the real and valid economic evidence and pragmatic evidence shows that Capitalism is more efficient in its use of scarce resources than is Socialism. However, it results in a distribution of real wealth which due to its essential dichotomy some see as being “unfair”; the reality is perhaps though that it is unequal rather than unfair. Provided arbitrary constraints are removed and suitable opportunities are established any citizen is able to rise above an unfortunate start of relative poverty, if they wish and work to do so. Grammar schools were one example of encouraging upward mobility.

      In truth though, both extremes are of course forms of “capitalism” since all modern economies require large amounts of capital to be able to function, and are thus capitalist. The difference is in the supposed “ownership” of that capital.

      However, I am afraid I disagree with your belief that true central bank independence (from political interference and currency debauchment) and a stable interest rate can in any way result in or cause the growth of debt mountains or asset bubbles. Rather, I believe that the reverse is true! A responsibly acting independent Central bank will take action to control potential inflation, and to prevent asset bubbles, whereas politicians in control will cause them by their failure to control inflation and base rate, but instead using these as a tool to balance budget deficits resulting from their own profligacy. In this respect it is important to select the staff in Central banks carefully and without political bias. If modern left-wing economists are put in charge of a supposed independent Central bank then it will tend to practice Socialist monetary policy, and thus in reality will not be neutrally independent, but ruinous, just as politicians in control would have been. Brown for example hand-picked the MPC members and senior BoE executives; as a direct result the present BoE and MPC practices Socialist monetary policy. This bias still now continues although we no longer have a supposed Socialist government in the UK, and already it seems that this is resulting in some conflict of views between the BoE and the new government and new Chancellor. (I believe it is true to say that not a single present MPC member is of the monetarist or Austrian economic wing.)

      For an economy to prosper in the longer term, enterprises generating the real wealth need an environment of economic stability. They need particularly a stable interest rate and low or non-existent inflation. This allows them to plan their costs, and to plan their ROI, without their plans being blown off-track by unexpected economic storms. This also encourages them to invest in R&D and new improved tooling and production methods. It also limits the likelihood of unexpected large wage demands due to increasing costs of living, again throwing ROI planning off-track. Economic stability thus allows enterprises to grow and an economy to grow and prosper, producing full employment and a good standard of living for the populace in that economy. It is low interest rates and inflation which is higher than those rates which leads to unrestrained borrowing and asset bubbles. That also causes enterprise destruction and failure. A falling real wealth generation in an economy and a transition to service activities to attempt to replace that can have similar effects, as we have seen in the UK to our cost.

      • Hi again Jonathan, I realised that I had omitted one important point previously.

        Another problem with the present model for independent Central bank operation is the use of one tool only to control credit and inflation – namely base rate. This does not work as effectively as is desirable. One of the main problems is the conflict between increasing base rate to reduce inflation, but this then also similarly hitting unintended economic sectors. In the past other devices have been used in addition to base rate, and these have shown some success. One example was to have effectively two base rates, one for private and personal borrowers, and another for commercial entities. By this method personal consumption on credit could be restricted whereas commercial borrowings were not hit. There were of course some weaknesses in this, since some individuals were able to circumvent the restriction and use commercial rates of interest to fund personal consumption.

        Nevertheless it is a fact that the present model of using base rate only has severe weaknesses and needs to be extended with other credit limiting tools to be more effective.

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