Bailey's policy experiment: QT or not QT?

The Bank of England looks set to enter an experimental phase of quantitative tightening. But will others follow?

Sentiment in the UK has moved against Quantitative Easing (QE) as a policy tool except during periods of financial market distress. Bank of England (BOE) staff are shortly expected to provide advice to the Monetary Policy Committee (MPC) on the sequencing of future policy tightening. The outcome of this review is likely to recommend the MPC use quantitative tightening (QT) alongside, or instead of, increases in Bank Rate. This would make the UK the first developed market economy to undertake such balance sheet normalisation, though the Fed’s experience in 2018 comes close. This policy experiment should be watched carefully as a signal that QE’s time has past.

A subtle shift in emphasis on the effectiveness of monetary policy tools has occurred in the United Kingdom over the past 12 months. This is expressed through growing disquiet about the effectiveness of quantitative easing (QE) in meeting monetary policy objectives except during periods of financial market distress—meaning systematic use of BOE balance sheet to meet the inflation target and, secondarily, support the government’s policy objectives might soon be dropped. Moreover, the Bank is contemplating balance sheet normalisation when circumstances allow.

This shift in sentiment against QE contrasts with the experience in other jurisdictions—the ECB, for example, just formalised asset purchases alongside other unconventional policies as a key part of their baseline toolkit. As such, not for the first time, the UK might be about to undertake an important monetary experiment that other developed market central banks will be watching carefully.

BOE asset purchase aggression

BOE asset purchases during the global pandemic were aggressive compared to peers. For example, holdings of domestic government claims increased close to 20 percentage points of GDP, greater than the Eurozone and United States (both roughly 15 percent) from 2020Q1. Of course, the UK does not lean substantially on other liquidity-providing tools—such as MBS purchases in the US or TLTROs in the Eurozone—so this comparison is incomplete. But the Bank cannot be accused of timidity in her policy response since the pandemic. Rather, there have been accusations that asset purchases almost perfectly mapped into the fiscal deficit, and therefore represents monetary financing!

Overall, BOE liabilities are closing in on GBP1 trillion as we approach the end of 2021, predominantly in the form of Bank Reserves. And the BOE balance sheet has been on an upward trajectory for most of the past decade.

Bailey the brave

The change in tone about use of central bank balance sheet as a policy tool began with Governor Bailey’s speech at Jackson Hole last summer, with accompanying working paper, “The central bank balance sheet as a policy tool: past, present and future.”

During that speech, Bailey recalled the standard channels through which QE is expected to have an impact: signalling, portfolio balance, and improving market liquidity.

But Bailey argued that the experience in the UK suggests that the impact of QE is highly state contingent—and mainly effective during periods of “market dysfunction associated with a widespread shock to liquidity demand,” less important as a policy tool during tranquil times. This liquidity channel was seen to be crucial both during the pandemic and the Great Financial Crisis. But, he argued, outside periods of financial market stress, the effectiveness of QE is less clear.

The tentative policy conclusion Bailey drew last summer was that when markets are functioning smoothly, QE should be unwound to provide balance sheet space to “go hard and fast” during future periods of market stress. That is, BOE should release gilts back into the market when circumstances allow, providing more safe assets available for purchase (if needed) later.

Staff policy review

Following this intervention, Bank staff were instructed in February to investigate balance sheet normalisation as part of any future tightening cycle. To wit:

…against the backdrop of the recent significant expansion in the scale of the Asset Purchase Facility, the Committee agreed to ask Bank staff to commence work to reconsider the previous guidance on the appropriate strategy for tightening monetary policy should that be required in the future. That previous guidance stated that the stock of purchased assets would be expected to be maintained until Bank Rate reached a level from which it could be cut materially. And, in June 2018, the Committee had agreed that it intended not to reduce the stock of purchased assets until Bank Rate reached around 1.5%. … this request to Bank staff should not be interpreted as a signal about the future path of monetary policy.

Quite when this guidance will emerge from the belly of Threadneedle Street is unclear, but next week’s Monetary Policy Report update—and revised inflation projections—is opportune. Conditional upon the course of the virus, as inflation concerns grow and the the tightening cycle comes into view, it is important to clarify the Bank’s position and explain this plan to markets.

Lords and the King

Echoing this changing mood, last week the House of Lords Economic Committee provided a report on the effectiveness of QE, authored by—among others—former Governor Mervyn King.

The report notes how “the scale and persistence of the quantitative easing programme are substantially larger than the Bank envisaged in 2009” agreeing that while QE “has also been particularly effective at stabilising financial markets during periods of economic turmoil. … [It] is an imperfect policy tool. We found that the available evidence shows that quantitative easing has had a limited impact on growth and aggregate demand over the last decade. There is limited evidence that quantitative easing had increased bank lending, investment, or that it had increased consumer spending by asset holders.”

The Lords report is cautious, however, as to the unknown impact on financial markets and the real economy from any attempt to unwind QE. Still, the report captures the mood in the UK and suggests the Bank “should expedite the review [into the sequencing of policy tightening] and we recommend that it sets out a plan for restoring policy to sustainable levels. The Bank should outline a roadmap which demonstrates how it intends to unwind quantitative easing in different economic scenarios.”

Pushing on an open door

In any case, within the MPC it is not only Governor Bailey for whom QE needs a rethink.

External MPC member Silvana Tenreyro in January expressed the view that QE “is important in the event of market dysfunction, for example, but also that its power mainly lies in helping offset the disruption, rather than providing net additional stimulus to the economy.” And this week, out-going External MPC member Gertjan Vlieghe likewise reiterated the state-contingent value of QE as a policy tool—in a speech from which high charts below are taken below. For Vlieghe:

the impact of QE on yields is not constant. There were large yield effects from the early 2009 and March 2020 QE announcements, in particular in early 2009,
effects from all the other programmes. In fact, if you exclude the early 2009 and March 2020 observations from the sample, the slope of the fitted line through the other QE announcements is close to zero… This analysis supports the idea that the power of QE is state-contingent: QE had powerful effects when market functioning was poor, but had much less impact when market functioning was good. 

And incoming External MPC member Catherine Mann last week told the House of Commons Treasury Committee that she has been for some time skeptical about the effectiveness of QE in impacting the real economy. Still, the question becomes how any unwind of support spills back into financial markets and hence the real economy:

It is not an easy decision and it is one about which we do not know enough. How does financial volatility, which might be precipitated by exiting some of the instruments, transmit into my real‑side remit? More work needs to be done to understand that linkage.

Experimentation in the UK

It would be a brave group of Bank staff not to embrace QT when they report back to the MPC in the near future. The debate about asset purchases in the UK has subtly changed in a way that has not happened elsewhere—or, at least, not yet.

While some developed market economies, such as the Eurozone, are doubling down on QE, and others are “only” contemplating tapering, the BOE is seriously contemplating balance sheet contraction during the next tightening phase of policy.

This means the UK will be, not for the first time in history, conducting a monetary policy experiment of global relevance.

What remains unclear for investors is how precisely this translates into a strategy for policy tightening—on which more information might become available next week.

A key question that will need to be answered by BOE is how QT changes the future path of rate increases. For example, should the rate cycle proceed as if QT were not happening, or should the rate cycle be more cautious because of QT?

The answer to this is not obvious. Years of research in praise of QE suggested it reduces the average interest on gilts or other government bonds, implying QT might put upward pressure on gilt yields and thus substitute for rate rises. However, implied by the general turn against QE in the UK, and as argued by Vlieghe this week, the yield impact is largely during periods of financial market stress; with clear communication and the a gentle balance sheet rolloff, the additional impact on the yield curve of policy tightening should be minimal.

For Vlieghe:

Clear communications are equally important when considering any unwind of QE. Small, gradual declines in the central bank balance sheet need not have any tightening effect in well-functioning markets, as long as there is clear communication on the desired future policy stance, in order to avoid sending an inadvertent signal that undermines the central bank’s intentions. Without such clear communications, even a small balance sheet reduction can result in a meaningful tightening of the policy stance.

This suggests the Bank Rate cycle need not be significantly altered in the event that QT is initiated, only that future Bank Rate intentions are carefully communicated.

However, QT has the potential to inject additional volatility into rates. Imagine, for example, a series of stronger-than-anticipated CPI prints while QT is selling gilts into the market. Could this add pressure on yields? Most likely the answer is: it depends. It depends on market conditions at the time and the impact of the inflation surprise on rate expectations. Hence Vlieghe’s emphasis on the need for clear communication.

But absent QE to lock-in timing of future Bank Rate increases, as at the moment, the need clear and credible forward guidance grows. Without the anchor of QE, what else does the MPC have?

Perhaps discretionary roll-off of gilt holding makes more sense? These are amongst the several questions for for Bank staff—and ultimately the MPC.

Concluding remarks

In any case, as so often the case, perhaps the most interesting impact of this policy innovation will be on the balance of payments and GBP—meaning, even if gilt yields are little impacted, the key impact of this policy could be a stronger GBP.

Since BOE does not conduct serious BOP analysis, reflecting on external flows will unlikely feature in their assessment. But given the continuing shortage of safe assets globally and ongoing QE elsewhere, it is entirely possible that the Bank will simply end up selling gilts to foreign investors in search of yield. Indeed, a striking but little commented feature of the enormous increase in gilts since GFC is that most of the net supply has gone to either non-residents or the Bank—leaving the float available for the domestic private sector largely unchanged. And if BOE selling is simply offset by nonresident inflows, QT could largely find expression through GBP strength.

If so, UK investors will instead be forced to rotate portfolios away from safe, reserve money claims on BOE towards foreign assets—and the money supply in the UK could contract as this rebalancing occurs. But this portfolio shift could end up increasing the risk profile of domestic investors, despite the professed desire of the Bank to release safe assets into the domestic financial system, while GBP strength hits the domestic manufacturing sector.

Unintended consequences often come to define the very best intentioned policies.