Time to tackle the UK’s quantitative easing problem
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The writer is director of the National Institute of Economic and Social Research and author of Money Minders: The Parables, Trade-offs and Lags of Central Banking
One consequence of the Bank of England’s dramatic intervention to prop up markets and the economy since the financial crisis is that the central bank and UK public finances are now left much more exposed to rises in short-term interest rates.
The BoE’s massive programme of bond buying known as quantitative easing lowered long-term interest rates and played an important role in avoiding a prolonged depression. But the scale and structure of the intervention has thus left the mix of the UK’s debt liabilities out of kilter, and the cost of that imbalance is mounting.
In quantitative easing, the BoE set up a subsidiary called the Asset Purchase Facility to buy long-term bonds. The APF paid for the bonds with new money in the form of electronic reserves created by the central bank. In turn, it pays interest on those reserves in line with the BoE’s benchmark bank rate.
At its peak, the APF had a liability of £895bn, or 36 per cent of gross domestic product. Such a liability means that the public finances are highly sensitive to decisions made about the bank rate by the BoE’s Monetary Policy Committee.
For several years, the APF produced profits and sent remittances to the Treasury, which were spent. The total amount remitted to the Treasury has been some £120bn. Now that interest rates have started to rise and gilt prices have fallen, we calculate that the APF has incurred unrealised losses nearly as large as the earlier profits which it remitted to the Treasury.
And there are risks on the Treasury balance sheet for years to come: if the APF’s assets are held until maturity, reserve balances held by commercial banks will still amount to more than £400bn at the end of 2030. If the bank rate was 3 per cent at that time, it would imply a payment to commercial banks of some £12bn in that year alone. The buying programme also left the structure of the government’s financial liabilities with a heavy concentration at zero maturity.
The BoE is rightly now contemplating a faster timetable for reversing quantitative easing. But there is a rather more fundamental issue — the necessary speed can be achieved only if the BoE works closely with the Treasury. It is the Treasury’s responsibility to manage the government’s debt — and that includes taking the sting out of the dramatic shortening in the maturity of UK government debt caused by quantitative easing.
The Treasury ought to have prioritised the management of the risk that such huge quantities of reserves posed. At rock bottom last year, funding costs were only likely to move in one direction. And while the risk is primarily a matter for the Treasury, the BoE, too, has an interest in it for several reasons. A central bank with a very large balance sheet is likely to have its independence questioned.
There is a tail risk of fiscal dominance of monetary policy, which, if it crystallised, would undermine the BoE’s ability to meet its price stability objective. And, as banker to the government, the BoE has an obligation not to act contrary to the government’s financial interests.
A year ago, economists Bill Allen, Philip Turner and I proposed a swap of a large part of the central bank’s overnight liabilities to the banks for a portfolio of short- and medium-term government bonds.
The central bank’s balance sheet would shrink, and the maturity structure of the government debt would be less risky and more transparent. And there would be demand from banks for the gilts to meet regulatory demands for holding high-quality liquid assets, mainly reserve balances and government securities.
How far the government yield curve would be affected by such an operation would depend on many factors. But such swaps have been successfully carried out in the past, most notably after the second world war.
The operation we proposed should be the beginning of a medium-term plan to lengthen the maturity of government debt. That might lift long-term interest rates somewhat but it would also mean that the central bank would raise short-term rates by less.
Interest rates are still very low and inflation is high. It is possible that global long-term interest rates are at the beginning of a sustained upward trend. This would happen just when the UK government is less prepared than it has been for decades. It has much more very short-term debt, and a much-depleted cushion of long-term debt. We need a clear debt management plan now to correct this.