On Friday lunchtime came news about a change in the operations of the Bank of England’s Quantitative Easing programme. Over the weekend I have seen it addressed by quite a few media outlets and I am afraid to report that the level of understanding displayed has not been great. So today I wish to explain what is happening and what the implications of it will be.
Was the announcement a surprise?
As several replies on the comments section of this blog were kind enough to point out I had addressed this issue back on the 31st of October when I discussed whether the UK had a “pot of gold” available. The crucial point is highlighted below.
The Bank of England subsidiary which holds the Gilts had £20.7 billion in cash as of its latest published accounts.
As the latest accounts were published at the end of February we can deduce that somewhere in excess of £25 billion is there now. That must have seemed like a lot of money to a cash strapped government that is in danger of missing its fiscal targets must it not? And even in these inflated times I can agree with that bit. Twenty-five billion pounds is a lot of money. In addition there is a continuing flow of funds from the holdings of UK Gilts which amount to some £375 billion.
So conceptually this was not a surprise but the exact timing was. Or at least I hope so because the UK Gilt future rallied quickly by nearly 0.8 points which would have been very profitable for those who were “more equal than others” as George Orwell famously put it.
What does all of this mean?
Let us start at the beginning
When QE began the Bank of England purchases UK Gilts in return for cash. It did not however hold the Gilts itself as it decided to set up a subsidiary to do so which was called the Bank of England Asset Purchase Facility Fund. It bought them and passed them onto it making a charge of the UK base rate for the funds.
So the Asset Purchase Facility became one of the most cash-rich companies in the world as it paid 0.5% for money and then received an average on 3.5% on it! We would all like to do that would we not? This year that will net it approximately £11 billion. However crucially for the changes being described here it was counted on many measures as outside the UK public sector finances and balance sheet. You can imagine how annoying that must have been for politician’s with itchy and indeed sticky fingers.
Why was it done like this? It has been my belief that QE operations were expected to be temporary. This is a very important point and a(nother) policy error. But for now let me just point out that I believe that those behind this hoped to close it down in something of a blaze of glory. A bit like generals in the First World War they expected to be home by Christmas. Instead,of course just like then quite a few Christmases have now passed.
What will happen now?
The Asset Protection Fund will lose its title as one of the most cash-rich companies in the world. It will now do this. From HM Treasury.
It is envisaged that the net coupon income earned by the APF during 2012-13, expected to be around £11 billion, will be transferred to the Exchequer during 2012-13. The excess cash that had accumulated in the APF up to the end of 2011-12 (£23.8 billion) will be drawn down over the course of 2013-14.
Now there are several ways of looking at this and the simplest is that it is a reshuffle of the UK public-sector’s balance sheet however it does have implications and I will address these in terms of monetary and fiscal policy.
The UK Monetary Policy Committee
We now know why the MPC capped -for now anyway- UK QE at £375 billion only the day before. I felt that vote could easily have been very tight. But this following announcement has an effect similar to that of QE. From HM Treasury.
If the APF’s gilt purchases remain at £375 billion, it is expected that around £35 billion of excess cash will have accumulated in the APF by the end of 2012-13
So ceteris paribus the UK will issue £35 billion fewer Gilts over this time period. So there will be a future monetary impact as £35 billion will not have to be found by investors to buy them. We do not know whether domestic of foreign buyers would have bought them but we can conclude that the UK money supply will be higher than otherwise. So some further easing.
Also there was this which I think has been missed by the reports I have seen. From the Chancellor’s letter.
The Bank of England will retain the option to reinvest the principal received from any redemptions and to maintain the size of the Asset Purchase Programme without having to borrow further funds from the Bank.
Tucked in there is the implication that the programme is now permanent. And if you excuse the capital letters I do mean PERMANENT. It does not actually say that but these things are like an oddly declining verb. I wont do it, you don’t need it, oh it’s here! That sort of thing,usually when they think no-one is looking. As the first Gilts bought under the programme mature in 2013 we will begin to find out then.
So as you can see I feel vindicated in my argument that the latest MPC meeting would see pressure for more easing. It has come in by a more indirect route but although quantifying an exact amount is not easy it is there. I also can see now why when I put myself forwards to be selected as an external member of the MPC in the autumn I did not get selected. The answer is to be found in the first part of the title of my blog.
I believe that there are likely effects here too particularly as time passes. Let us first examine what we are being told will happen to the funds received by the UK Treasury.
All of these cash transfers are expected to impact on the Central Government Net Cash Requirement
As Chancellor George Osbourne does a jig round his office he does not want us to know how happy he is so we are also told this.
any net coupon income transferred from the APF to the Exchequer should be used solely to pay down government debt
If this was simple number we could tell but in truth there are so many pressures on it as we move into the future it will be virtually impossible to tell,especially as we are also told this.
The Office for National Statistics will decide on the classification of these flows and thus their impacts on fiscal aggregates
Odd that nobody appears to have thought of this is it not? Or perhaps,ahem, only one person as I asked the ONS about such issues a while back and again oddly an often extremely helpful organisation never replied. Anyway if you read their rules on the treatment of Gilt coupons and so on you kind of get the feeling that it will be counted eventually if not right now. Also if you follow the logic you will see that in what I am sure is a complete coincidence of timing the main boost will come in the run-up to the next election.
Again quantifying the exact impact is not possible because we are discussing the future and it is like trying to peer to the bottom of a muddy pool. Please remember that when we get the promises of fiscal straightjackets etc. In truth it is impossible to police and so we can be confident of the outcome which will be an overall looser fiscal policy.
What has been brushed aside?
This bit as I discussed on the 31st of October.
The catch is just like the currency carry trades I have described for the Swiss Franc and the Yen you also have a capital risk. As the capital is £375 billion you can see that there is a substantial risk where £20.7 billion represents a 5.5% swing which does not sound a lot put like that.
Or as the official statement puts it.
As part of the process of tightening monetary policy, the MPC may decide to sell part or all of its gilt portfolio over time. As gilts are sold or redeemed, it is likely that the proceeds will be lower than the original purchase price (if gilt yields are higher and gilt prices lower than at the time of purchase). And if gilts were held to redemption rather than being sold, the redemption value is likely to be lower than the purchase price paid by the APF, since most of the gilts were purchased above par.
Nice of them to (finally) agree with me. Put simply they now expect capital losses as they should in my view.
Can anybody see a flaw in booking carry profits now and ignoring the likely capital losses in the future? Was not Enron run with that type of accountancy “system”?
So we have seen a substantial easing of UK policy announced with both fiscal and monetary components. Is it debt monetisation? That has become a shades of grey rather than a black and white argument and it is a shade darker now. Regular readers will recall I discussed another shade darker on July 11th (on my Mindful Money blog). That day the UK Debt Management Office issued more of a Gilt stock that the Bank of England had previously bought only eight days before.
Or you can take the official view that the move is to do this.
align our practices with those of major central banks like the United States Federal Reserve and the Bank of Japan
Of course then you have to take the full official view which is that the UK is always about to get inflation on target and economic growth is always just about to surge.
It also has me wondering about the value of the pound. This is something which one would not have predicted pre credit crunch. The problem is that to sell it you have to buy something else and so many are at the same game.
Thank you to who referred to me in the Greek edition of Kathimerini over the weekend. I tried to translate it and track it down but failed but it is good to see my message being spread ever more widely.