To Infinity! And Beyond! The Bank of England and QE

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
reserves holders.

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
purchased assets.

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.

Comment

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

 

 

29 thoughts on “To Infinity! And Beyond! The Bank of England and QE

  1. One of the most important things which came out today which relates to your header was the Fiscal Risks Report on a no deal BREXIT.

    Despite all the warnings by Carney that interest rates could go either way, so far as my understanding of the report today was that interest rates would be cut.

    Lets face it that would be needed to boost the economy and at the moment it looks like a no deal is the way we are going.

    Having listened to Duncan Smith MP on the BBC news this morning he has made it clear if Borris is elected as leader, the European deal is dead and we come out at the end of October come what may!

    So there we have it Treason May should have spent the last 3 years preparing for a no deal she is partly responsible for the present situation we could have been out by now and well prepared for an exit.

    I happen to think things wont be as bad as the worst case scenario as Europe has more to lose than Great Britain.

    I say Great Britain as we were the most profitable country in the world at one time and with the right leader we could climb to the top again.

    • how do you even measure the profitability of a country, let alone determine which country is the most profitable? Why would you want a country to be profitable?

      • you mean like Japan?

        well yes actually , I like that idea , you know making stuff and selling at a profit

        why would you not want your country to be “profitable” ?

        like Greece ?

        Forbin

        • Riddle me this then Forbin, if every country runs at a ‘profit’ who is running a deficit to finance these profits? The profit you refer to is called a surplus and every surplus needs a matching deficit. The whole notion of profits for a country is absurd.

      • Queen Victoria said “the sun doesn’t set on my empire” is part of the answer.

        Great Britain led the world in Victoria’s reign we had the biggest navy in the world and the most modern achievements at the time is another example of Great Britain being the most profitable country in the world.

        Brunel was the most envied engineer in the world who designed and built dockyards, bridges and railways not to mention he first propeller-driven, ocean-going, iron ship, which, when built in 1843, was the largest ship ever built.
        https://en.wikipedia.org/wiki/Isambard_Kingdom_Brunel

        Great Britain were the world leaders in cotton exporting all around the world we employed millions in UK factories.

        We built fantastic tunnels and sewer systems many Victorian sewers still in use today.

        Even today we are the world leader in graphene and still have some of the best universities in the world many foreigners prefer to be educated in the UK.

        • More on Great Britain’s achievements and evidence of Great Britain’s wealth :
          http://www.bbc.co.uk/history/british/victorians/victorian_technology_01.shtml
          A powerful trading nation

          “During the reign of Queen Victoria Britain emerged as the most powerful trading nation in the world, provoking a social and economic revolution whose effects are still being felt today. Since the latter part of the eighteenth century the process of industrialisation had built a firm foundation for nineteenth century growth and expansion. At the heart of this was the successful development and application of steam technology. Before 1800 brilliant engineers and entrepreneurs such as James Watt and Matthew Boulton had made steam power a practical reality that had radically improved Britain’s core industries, namely the mining of coal, minerals and other raw materials and the production of iron, textiles and manufactured goods. With its advanced industrial technologies Britain was able to attack a huge and rapidly expanding international market.
          Between 1809 and 1839 exports grew from £25.4 to £76 million. Ten years later the figure was £124.5 million, with the major export markets being Europe, India and Asia and, increasingly, the United States. At the start of Queen Victoria’s reign, Britain’s standing as a global industrial and trading power was already unrivalled. The complex structures of international trade developed by the Victorians and the maintenance of the process of wealth generation derived from them were dependent upon efficient means of communication. In many ways, the Victorians owe their unique place in history to their imaginative and successful exploitation of three new communication technologies, the steamship, the railway and the electric telegraph.”

  2. Yes they have made a right mess of it, but how long can it go on like this? Japan has had nearly thirty years of it, but has massive forex reserves and a huge trade surplus with which to fund the insanity and the luxury of a strong currency, the UK has none of the above and virtually all its gold was famously sold off for about $260 an ounce by Gordon Brown. The continued use of currency debasement and zero interest rates and QE and the high inflation to come will destroy all savings and pensions – for what?- to keep house prices up and share prices elevated?

    Is there a plan at the end of all this or are they just hoping something will change and the problems of stagnant economies and low inflation go away or will it continue until there is either a revolution or a complete economic collapse brought about by currency collapse?

    The stockmarket and the housing market now have to be supported as they are the only source of economic growth, QE can never end and interest rates can never go up.

    I feel like one of those people on an operating theatre table being operated on and able to feel and hear everything going on around me but unable to stop it.

    • what precisely are your concerns with QE?

      If, 10 years ago or so, the UK Treasury had decided to run a larger deficit than planned, by spending a little more and collecting a little less tax (which it did), but instead of financing the deficit by issuing exclusively long dated fixed rate bonds, it had decided to issue some fixed rate and some floating rate bonds, with the floating rate bonds having a coupon referencing Bank Rate (lets say Bank Rate flat, no spread), which might have been attractive to and have mainly been bought by commercial banks, would you have had the same concerns?

      • The point you seem to be missing is that central banks changed their mandate without anyones notice or reference, they interfered with the interest rate setting process – ie the price of money, that determines so many things in the economy – and in the process encouraged and financed a further orgy of speculative excesses and malinvestments and consequently have now backed themselves into a corner from which there is no escape other than an inflationary collapse or a deflationary one many times greater than would have been suffered had they not interfered and rates were determined by the market in 2008.

        Left on its own, market rates would have risen, bad debt, bad investments and zombie companies would have been expunged from the system with many defaults and bankruptcies, but nothing like the catastrophe that awaits when this insanity comes to its final conclusion.

        You seem to also suggest that the BofE merely took the place of buyers in the market, conveniently ignoring the fact that if the bank hadn’t made purchases of such magnitude, rates would never have gone as low as they did and the bubbles in the bond and property markets would never have been extended as far as they have been, the fact that this has been going on for over ten years means there has been so much money thrown at housing, car finance and consumer credit that they can never reverse their policies, the reckless property speculators are rewarded and savers and pensioners are wiped out.

        A price worth paying no doubt?

      • The process is asymmetric.

        If the government had sold bonds they would have to reduce the price to make them attractive and market rates would go up. The money supply would fall as a result of the sale.

        With the BOE buying bonds they can buy them at market rates to both support prices and, by derivation, at least keep interest rates steady if not reduce them. In this case the money supply increases which adds liquidity to the banking system.

        • when the Treasury sells bonds to the non-bank private sector, broad money that the government adds to the system by running a deficit, is destroyed (or suspended). To be more precise, when the Treasury sells bonds to GEMMs, there is no effect on the broad money supply. Only when GEMMs sell those bonds to non-banks is the broad money supply reduced.

          If the Treasury had sold floating rate notes to banks, with the intention that banks should hold on to them to meet their new liquidity requirements, the broad money that the Treasury had added to the economy by running a deficit would have remained in circulation.

          If that had happened, the balance sheets of the government sector, the banking sector and the non-bank sector would look more or less as they do now. Interest rates, both long and short, would be more or less as they are now, the only difference being nobody would be banging on about how ‘the precious’ had been favoured, how they had been ‘bailed out’ or how asset prices had been ramped up or inequality made worse.

          The actions of the Treasury, in running a larger deficit than planned and thereby adding more net financial assets to the private sector, plus the actions of the central bank in allowing some of these assets that the Treasury added to remain as broad money did none of these things.

          • “If the Treasury had sold floating rate notes to banks, with the intention that banks should hold on to them to meet their new liquidity requirements, the broad money that the Treasury had added to the economy by running a deficit would have remained in circulation.”

            Surely this begs the question. If the Treasury runs a deficit and borrows to finance it then that extracts money to the value of the deficit; this adds nothing to the money supply; in fact the supply contracts. It only adds to the money supply if it monetizes the spending.

            “If that had happened, the balance sheets of the government sector, the banking sector and the non-bank sector would look more or less as they do now. Interest rates, both long and short, would be more or less as they are now, the only difference being nobody would be banging on about how ‘the precious’ had been favoured, how they had been ‘bailed out’ or how asset prices had been ramped up or inequality made worse.”

            When you say “if that had happened” it seems to me that it’s unlikely to happen because of the above.

            Surely the idea behind QE is that banks take the new money which they receive to buy new assets; stock prices rise and interest rates are lowered.

            Whether the balance sheets look more as they are now is beside the point surely; the idea behind QE was to influence real economic activity not to change accounting identities.

          • “If that had happened, the balance sheets of the government sector, the banking sector and the non-bank sector would look more or less as they do now. Interest rates, both long and short, would be more or less as they are now”

            Quite an assumption there Robert, but I will say again, in the circumstances of 2008, that would not have happened, and you conveniently ignore the persistent Bank of England bid driving down interest rates below that would have otherwise occurred, the simple fact is the banks were bailed out by driving rates lower than they otherwise would have been and bond and property bubbles were reflated to ensure bank balance sheets did not deteriorate further, IMHO many UK banks are STILL insolvent now, their losses being hidden off balance sheet, and this is reflected in their depressed share prices together with the fact that all the measures being currently undertaken to prop up the bond and property bubbles are perversely hitting the very loan margins of the banks they are trying to save!

            Quite simply our economy and that of the EU and the US has become so financialised and debt hobbled to respond to these measures, the solution to an economy with too much debt cannot possibly be more debt, this has led to
            an economy run for speculators and the rentier class that are extracting more and more form a dying patient, the cost of housing – whether it is rent or mortgage is now such a high proportion of peoples disposable income that consumption and demand in the rest of the real economy is is on a permanent downward path, the property market is simply sucking the life blood out of the real economy.

            So QE, which you so eloquently defend and being such a cunning plan to extricate us from the mire of 2008 is so successful ten years later that the cure to the failure of the economy to respond to the treatment is to do more of it……..over to you Shaun to finish this one off !!!.

          • Kevin

            “Quite an assumption there Robert”. Not my assumption but Robert Pearson’s.

            You’re right about the banks. But QE provides liquidity but people confuse liquidity with solvency. If you have a lender of last resort you should not have technical insolvency because technical insolvency is about having the capacity to discharge your liabilities – it’s about liquidity. What we’re talking about is actual insolvency and I agree that some, if not most, of the banks are actually insolvent. And I’m not talking about fire sale insolvent; I’m talking about the orderly disposal of assets over a number of years.

    • The U.K. authorities will soon lose control over interest rates as the pound sinks, inflation takes off and the bond markets panic. “Sources are reporting that the Fed, ECB, and BoJ have agreed to lobby politicians in an attempt to warn them that they cannot continue propping up the world economy. The ECB, in particular, has been keeping the EU on life support and they have no room to lower interest rates to try to support their economies any longer. They are beginning to argue that they need help from governments in the rescue effort, which will fail. Even in China, economic growth has declined to its lowest point since 1990. The slowing global economic growth has pushed the Federal Reserve, European Central Bank, and perhaps even the Bank of Japan to look at more Quantitative Easing. However, the Fed, especially, wants no part of buying government debt. The cries behind the curtain are that monetary policy alone in the coming months cannot support the economy. There is just less room to act with regard to interest rates than in the past. This has been the pitch in Brussels as the ECB is warning politicians they will need to assist if a downturn takes hold.”

  3. Hi Shaun, your blogs seem to have had a theme this week which is all economics is currently backwards and reversed, almost like we’ve entered a parallel universe. Only 10 short years ago anyone suggesting that negative interest rates would be normal would have been heavily sedated and gently ushered into a padded cell.

    So on reversing QE it’s won’t happen because it’s impossible. QE was a gift to ‘the precious’ basically free money. The BoE has not expanded it’s balance sheet because that’s also impossible given the fact it’s balance sheet is infinity minus one penny. The BoE can issue as many bonds as it wants so why would it need to buy any?

    QE is nothing but accounting skullduggery and a bail out by any other name. So no, we will never get the money back.

    • Hi bill40

      I am a firm believer that you should not get yourself into things without a plan for getting out, usually called an exit strategy. I have been watching some documentaries this week about the Apollo missions due to the 50th anniversary of Apollo 11 and those missions had a way back. If our central bankers had been in charge the LEM would have arrived on the moon and only then would they have thought it might have been better to have brought a rocket engine so they could return to earth.

  4. Do you know, Shaun, that I really look forward to you daily email and blog cutting through the fog of it all. Many thanks.

  5. Shaun there is an endearing quality to your blogs , its that the system should work for the benefit of ordinary folk. There was a very short period in human history and I was there, mid-50s to mid-70s when there was a chink of possibility this was happening. But the gates got quickly locked after Nixon went fully fiat.
    Now the elite are fully back in control, BIS and CBs planning for global negative rates and MMT. The rich will pluck the rewards the rest will pay through taxes and loss of money value. They all pull together, nowhere for anyone to run. No cash, its all edollars, esterling etc.
    Worst thing is ‘they’ don’t give a fig about joe blogs, ‘they’ are insulated from such problems.

    • Hi Jim,
      No the CB’s are not planning for MMT because it’s already here, it merely describes the system as it works today. They will use MMT like they use Socialism it’ll be for the rich only, us plebs will be fobbed off with crony capitalism and scarce money. What a wonderful world.

  6. Great blog and video as usual, Shaun.
    I am posting an additional comment on your blog from yesterday here as it would probably get fewer readers if I posted it there.
    One of the oversized contributors to the drop in the RPI inflation rate in June was UK holidays, whose 12-month percentage change went from 5.7% in May to 5.1% in June. Unfortunately, the measured change is unreliable, since the 12-month percentage change for January 2020 will give a reliable estimate of the average annual price change for the fiscal year ending in January 2020 as compared to the fiscal year ending in January 2019, while all the estimates for February 2019 through December 2019 are essentially intermediate calculations, leading up to the January estimate.
    The ersatz seasonal formula now used for holiday trips is similar to the exponential smoothing of house prices in the RPI depreciation component that you mentioned yesterday. Just as the exponential smoothing dampens and delays the impact of reduced house prices, so the use of this unusual seasonal formula dampens and delays the impact of reduced holiday prices.
    On July 18th I gave a presentation at the annual meeting of the Canadian Agricultural Economics Society on the Farm Product Price Index, the Canadian counterpart to the UK Output Agricultural Price Index. Both indices use the monthly-weighted Rothwell formula; the UK index just for potatoes, fresh vegetables and fresh fruit, the Canadian index for all farm products. There were twenty-some people at our four-paper session, so that number of mostly North American economists would now be aware that an esatz monthly-weighting formula continues to be used in UK consumer price indices more than a decade after the far superior Rothwell formula was abandoned for seasonal food groups.
    It had puzzled me in the past why the 1993 RPIAC report on “Treatment of Council Tax and Holidays in the Retail Prices Index” did not recommend the Rothwell formula, already used in the RPI, instead of inventing a new one. I now wonder if it wasn’t because they prioritized a good measure of annual average change, and they didn’t get that with the Rothwell formula as it had been implemented in the RPI. The Rothwell formula as described by Doris Rothwell in her 1958 paper required the annual index to be calculated as a weighted average, rather than a simple average, of its monthly price index numbers. The 1974 RPIAC instead recommended that the Rothwell formula (although it didn’t call it that) be used to calculate the monthly index, while the annual index continued to be calculated as a simple average. At the time it probably seemed like a sensible compromise in a noble British tradition. However, it set things up for failure when the RPIAC came to enlarging the scope of monthly weighting in 1993. When (not if) the Rothwell formula makes its way back into UK consumer price indices the ONS mustn’t make the same mistake. An annual Rothwell index should always be calculated as a weighted average of its monthly price index numbers.

    • Hi Andrew and thank you

      The Rothwell formula seems logical to me so I am unsure as to why it was not consistently used. I am seeing someone next week who I think may have been involved in the 1993 RPIAC so will try to remember to ask.

      Your point about the seasonal treatment is particularly valid for holidays compared to house price depreciation. After all a holiday in the school holidays is different to one outside which hardly applies to a house.

      How much of an error do you think that this can create?

      • Thank you for your response, Shaun. I hope that your friend can clarify why the 1993 RPIAC did not choose to go with the Rothwell formula for holidays. To know the empirical magnitude of the lag in incorporating price changes you would have to look at actual data, but a highly stylized example will give you a feel for it. Suppose that holiday prices are unchanged between February 2019 and January 2020, then drop by 24% in February 2020, then remain constant through January 2021. Assume also that the months are all equally weighted. The February 2020 monthly change would be -2% (1/12 of 24%), not 24%, the change from January 2020 to March would be -4%, not -24% and so on, until the January 2020 to January 2021 change of -24% correctly measures both the 12-month percent change (exceptionally) and the annual-average percent change, as it always would. So the lag is quite unacceptable.

  7. 2043, 2050, 2060. Gee Shaun,
    Why would any young adult in their 20s save or start a pension plan ?
    The moral has to be spend (or borrow and spend) today.
    And if you borrow make it a “Robert” loan. They don’t need to be paid back.

    Crazy stuff

    • Hi Eric

      Yes “spend, spend.spend” like the woman ( Viv Nicholson I think) who won the Pools all those years ago. The British consumer seemed to have that in mind in June.

      “The year-on-year growth rate shows that the quantity bought in June 2019 increased by 3.8%, with growth across all sectors except department stores, while May 2019 was at 2.2% for the year-on-year growth rate.”

      But countries like Sweden who have had negative interest-rates for several years now still seem to save, so the picture remains complex. It may just be, though, that behaviour changes slowly.

  8. Pingback: To Infinity! And Beyond! The Bank of England and QE - Free World Economic Report

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