- After 12 years of low inflation and loose monetary policy, the economic outlook has changed significantly
- Higher interest rates and the onset of quantitative tightening present new challenges for the BoE
Quantitative easing (QE) has been around in the UK for so long now that calling it 'unconventional monetary policy' was beginning to feel slightly ill-fitting. First introduced over 12 years ago, QE bolstered the Bank of England’s (BoE) monetary policy firepower in the aftermath of the financial crisis, with large-scale asset purchases buoying the economy once there was little scope for further interest rate cuts.
The combination of low rates and QE created what the BoE’s Huw Pill last week described as a “highly accommodative stance”. This was maintained for over a decade – justified by persistently low inflation and the subsequent shocks of the euro crisis, Brexit referendum and coronavirus pandemic. QE, it seemed, was well established.
But as the chart shows, times are changing: as inflationary pressures have mounted, so has the drive to tighten monetary policy. The Bank now faces the challenge of rolling back QE – using quantitative tightening (QT) – against the backdrop of sharply rising interest rates. This is all uncharted territory.
The first challenge of winding back a decade’s-worth of asset purchases is the impact on financial stability. In a speech last week, Pill explained that the Bank has tried to mitigate the adverse impacts by ensuring the QT programme is as gradual and predictable as possible.
But the Bank was nevertheless forced to pause asset sales during the gilt market turmoil that followed September’s 'mini' Budget. Although a temporary intervention staged in the interests of financial stability, the episode saw the Bank delay QT at the same time as raising interest rates – a policy stance that Capital Economics’s Ruth Gregory described as “horribly muddled” at the time. Pill noted last week that financial stability measures do not work in isolation, and argued that by impacting asset prices and overall financial conditions, they can prove “highly relevant” to rate setting decisions.
Sharply rising interest rates have also highlighted an overlooked (though by no means unrecognised) feature of the QE programme – its impact on public sector liabilities. As an Office for Budget Responsibility (OBR) briefing from last summer sets out, under QE bank reserves (floating rate debt) are used to purchase gilts (long-term fixed-rate debt) which increases the sensitivity of interest payments to changes in the interest rate.
The sharp rise in interest rates this year means that the Bank of England is now paying higher interest on commercial bank reserves. At the same time, it is reducing its stock of gilts – meaning lower income from coupon payments. As a result, the Treasury has started to make payments to the Bank’s Asset Purchase Facility (APF) to cover the difference. This marks a significant turnaround: OBR figures show that between 2009 and 2022, the APF paid lower interest on its reserves than it received in gilt coupons, and remitted £120bn to the Treasury as a result.
According to Ashley Webb, UK economist at Capital Economics, matters are worsened by the fact that the Bank effectively bought gilts high and finds itself selling them low, meaning “the Bank makes a 'loss' every time a gilt it holds matures or is sold”. The Bank purchased many of its gilts above par but is selling them below par: yields have risen significantly since it purchased the gilts, and prices have moved inversely. The OBR estimates that the Treasury may need to pay £133bn to cover these losses over the next five years.
In an October report for the Institute for Fiscal Studies think tank, economist and former central banker Paul Tucker argued that “the Bank’s monetary techniques” were distorting the British state’s debt structure in “unfortunate ways”. But what to do about it is less clear: at a high level, he argues that the Bank could change the way it operates reserves. But while this would benefit public finances, it could come at a cost to efficiency, credit conditions and, crucially, central bank credibility.
As rates rise and the Bank embarks on active tightening, we enter a new (and uncomfortable) phase for QE: the difficulties facing the Bank remind us how much we still have left to find out about this unconventional policy tool.
