Quantitative easing goes into reverse

Since it was first introduced in 2009, quantitative easing (QE) has moved from an ‘unconventional policy tool’ to a pillar of UK monetary policy, as my chart shows. Since March 2020, the Bank of England (BoE) has doubled the size of its QE programme, and by 2021 it owned £875bn of government bonds plus £20bn of corporate bonds – equivalent to around 40 per cent of UK GDP. 

But the central bank's asset purchase programme now stands poised to go into reverse. The BoE began ‘passively’ reducing the size of its balance sheet in February, by no longer replacing assets that had matured. From this month onwards, the BoE is expected to embark on a period of more aggressive asset sales, or ‘active’ quantitative tightening (QT). This is uncharted territory.

Unfortunately for policymakers, forecasting the impact of QT is not as simple as reversing the effects of QE. While QE was introduced suddenly in times of stress, the central bank intends to move slowly with QT. The BoE plans to reduce its stock of gilts by £80bn over the next 12 months, and will do this through a combination of passive QT and active sales of around £10bn per quarter. 

BoE governor Andrew Bailey also argues that the impact of QE itself is actually “quite slight”, with its effects a function of the underlying economic climate. Bailey maintains that QE has a bigger impact when the economy is in a stressed condition or crisis, concluding that QT will not have a “big impact on market interest rates” because it will be concentrated in periods of stable markets. Yet this hardly feels like a time of calm.

ING developed markets economist James Smith argues that “gilts are skidding off-road”, with a renewed jump in energy futures and the UK’s soaring inflation rate causing significant jitters and pushing yields on UK government debt to levels not seen for more than a decade. Markets now expect steeper rate hikes, meaning that UK gilts are sharply underperforming their US and European peers. Smith argues that this casts a “long shadow” on the BoE's planned QT. Even at the best of times, any measure of QT will force private investors to increase their exposure to gilts by the same amount as is being sold -– if prices are to remain stable, that is. Can the market really accommodate this level of gilt sales today? 

It is also unlikely that QT will do much to help with soaring CPI – in spite of research suggesting that earlier rounds of QE did have an inflationary impact. The BoE compiled the results of 16 studies and found that the first tranche of QE in 2009 increased inflation by around 1.8 percentage points. Common sense seems to suggest that high levels of QE must be contributing to today’s high inflation rates. But the evidence is far from clear. 

Modelling by Panmure Gordon found that stopping QE in the first half of last year would have made little difference to peak inflation. BoE governor Bailey has also argued that asset purchases have not fuelled the UKs double-digit inflation rates. By his logic, if QE were a significant driver of inflation today, domestic demand would be much stronger than it currently is. Tellingly, the monetary policy committee is not relying on QT as an inflation-buster: August’s minutes stress that the committee still sees interest rates as its active monetary policy tool. In short, QT may do less to tackle inflation than we might hope. 

Should the tightening still go ahead? ING’s Smith states that “we don’t argue that the plan should be shelved, but a clear circuit breaker, which helps avoid adding to market stress, would make sense in our view”. The BoE intends to embark on QT “subject to economic and market conditions being judged appropriate and to a confirmatory vote” in their September meeting. Their decision on whether to press ahead or not will be telling.