It is nice to be proven correct and the business of Bank of England Governor Carney applying for the role of managing director of the IMF is something I suggested years ago. But today I wish to stay with the Bank of England and look at the future of its biggest monetary policy experiment which is what has become called QE or Quantitative Easing where it expands its balance sheet. So let us open with a how much?
Three quarters of the Bank’s assets is in the form of a loan to the Asset Purchase Facility backing £435bn of
gilt holdings and £10bn of corporate bonds, while another £127bn has been lent to banks under the
Term Funding Scheme . A further £13bn of liquidity has been extended under the so-called ‘Index Linked Term Repo’ facility, part of the Sterling Monetary Framework (SMF).
That gives us a total of £585 billion although some care is needed because you see the Term Funding Scheme is in but the preceding Funding for Lending Scheme which as of the last update still accounts for £10 billion is not. So whilst we have precision as so often care is needed with the definition as similar policies in terms of effect ( in this instance promising to boost business lending but somehow boosting mortgage lending instead) can be treated very differently. On that road the Term Funding Scheme managed to be added to the national debt which might have mattered a lot but due to circumstances ( bond market boom) has been much less of an issue than it might have been. Another way of looking at it is below.
Before the financial crisis, our balance sheet was modest, at 4% of GDP. Since then, and in direct response to the
crisis, that figure has risen to around 30%: a more than seven-fold increase.
These figures are from a speech given by Andrew Hauser who is an Executive Director at the Bank of England and he churns out something which could have been spoken by Sir Humphrey in Yes Prime Minister.
‘Too large’, and central banks may find themselves accused of usurping the role of financial markets,
harming innovation and inducing imprudent behaviour; fuzzying the boundary between monetary and fiscal
policy, providing a ‘dangerous temptation for … the political class’ ; or giving unmerited financial rewards to
Actually this is what they have done and for those of you wondering about the last bit let me explain. One of the features of the QE era is that as the balance sheet has to balance there needed to be reserves on the other side of it and they get Bank Rate. When central bankers talk about there being market pressure for lower interest-rates this is what they mean.
The excess of reserves pushes down on overnight markets rates, but they are prevented from falling much below a floor of Bank Rate by the fact that banks can borrow reserves in the market and earn Bank Rate by depositing them at the Bank of England.
You may note that this is also a response to central bank policy something which they forget. Also let me address this bit.
And rates have indeed been closer to Bank Rate on average than at any point in the past twenty years.
This is both true and misleading. In the money markets this is a success as for example the US Federal Reserve has had its troubles with this ( if you see the acronym IOER that is what they are referring to). But outside that in the real economy it is misleading as so many have diverged from Bank Rate. You do not need to take my word for it as the existence of QE proves it. Putting it another way I pointed this out around 9 years ago when I started blogging and it is still true.
Returning to Bank Rate as being a reward that seems odd as it is a mere 0.75% so let me give you a couple of perspectives. It is compared to the ECB Deposit Rate of -0.4%. But if we stay with the UK you might say dip into a short-term Gilt but the one-year yields 0.59% and the two-year 0.53% so compared to them Bank Rate is a reward.
How will we engage reverse gear?
We get a statement of the obvious.
Just as QE increased the quantity of central bank reserves, QT will reduce it.
For newer readers QT stands for Quantitative Tightening and means this.
But at some point, as part of a future tightening strategy, the time will come to start reducing the stock of
Okay how will this happen?
First, the MPC does not intend to begin QT until Bank Rate has risen to a level from which it could be cut materially if required. The MPC currently judges that to be around 1.5%.
There is a problem with the “currently judges” as a note to the speech points out.
This judgment was adjusted down from around 2% in June 2018, reflecting revised estimates of the effective lower bound for Bank Rate.
That is revealing in many ways and evokes memories of the way that the so-called equilibrium unemployment rate found its way from 7% to 4.25%. After all when you move things that much you lose pretty much all credibility. The issue of the effective lower bound was created because Governor Carney pointed out several times that he thought it was 0.5%. So he effectively torpedoed his own logic when he cut to 0.25%. Amidst the embarrassment, the Bank’s Ivory Tower suddenly decided that the lower bound for Bank Rate was 0.1% using the Term Funding Scheme as its sword.
Second, QT will be conducted over a number of years at a gradual and predictable pace, chosen by the MPC in light of economic and financial market conditions at the time.
That is ominous as it echoes the language of the talk about interest-rate increases as we have had Forward Guidance for at least five years now but net only one increase of 0.25%! Actually in the current environment even that may go later this year but that is not for today.
Third, the QT path will take account of the need to maintain the orderly functioning of the gilt and corporate bond markets including through liaison with the Debt Management Office.
Who could possibly have thought that buying some £435 billion of something would fundamentally change the Gilt market? Actually more trouble may come with the corporate bond market because it was not especially liquid anyway and being a (relatively) large seller will not be easy.
And, fourth, the QT path can be amended or reversed as required to achieve the inflation target.
So the QT path might involve more QE. It is hard not to laugh but once our mirth fades that is of course the road that the US Federal Reserve may now be on.
Let me address my “To Infinity! And Beyond!” point. At the current rate of progress Bank Rate will reach 1.5% around 2033. Should the Bank of England then decide it was right about 2% then we move onto around 2043. You get the idea which is rather like what has happened with the maturity of Greek debt which is always kicked further into the distance. The situation regarding timing gets worse should we see further cuts in interest-rates which right now are a lot more likely than rises. 2050s? 2060s?
In a way Mr. Hauser addresses this in his speech but he misses a crucial point.
When might this all start? No time soon, if you ask the financial markets! The current forward yield curve
does not reach 1.5% at all . But options markets price in a small probability of it occurring, and (as
the chart shows) expectations can shift quite rapidly: less than a year ago the implied central case start date
was in 2021.
Interest-rate expectations have shifted downwards time and time again in the credit crunch era and been matched by events. However expectations of interest-rate rise have not be matched by reality, otherwise the ECB and Federal Reserve would be raising later this month rather than either cutting or laying the groundwork for one.
Next let me address options markets as you see I used to be an options market-maker. Why would you price it at zero? Someone might want to buy so you make them pay for it. That is completely different to believing it might happen.
I have long believed that the Bank of England has no intention of reversing QE and this is also confirmed by the speech itself. After all with respect to Mr.Hauser if something was going to be done this would be a subject for the Governor not a mere executive director.
The Investing Channel