Over the last decade, since the 2008 global financial crisis, central banks have proved to be the shock absorber for the global economy. They have become the best friends of financial markets and of those who own assets. Interest rates have plummeted, effectively falling to zero in many western economies. Money has been printed through Quantitative Easing (QE) and forward guidance has made it clear that we should not expect any shocks. Policy has not just been accommodative, it has been predictable, too.
Low inflation has provided the underpinning for this global policy approach – although one should not overlook that asset price inflation has been rampant, with the prices of equities, houses and bonds all surging. The latter, it could be said, largely because of QE.
When interest rates are so low, markets do not price properly for risk, it is hard to determine what qualifies as a risk-free asset, and there is a tendency for some to search for higher yield.
In the UK the stance of monetary policy is accommodative. Policy rates are 0.1%. The BOE’s balance sheet has soared as it has printed money via QE. It does this by issuing central bank reserves to buy bonds: its current plans are to hold £875 billion of gilts and £20 billion of non-investment grade corporate bonds.
Such corporate bond buying never seemed justified, likewise I would also not support the idea of negative interest rates, particularly now.
Negative rates: an option the BOE may not use, or need to
The recent press speculation about negative rates was triggered by news that the BOE will have added negative rates to its policy toolkit from this autumn. The fact it is taking so long to add to the toolkit is a sad reflection on the IT systems of banks, not on the BOE’s stance. Having this option in its toolkit naturally makes sense for the BOE. That is not so say that they will then use it.
There have been mixed signals from the Monetary Policy Committee on negative rates this year, with some members speaking in favour. Most notably being Silvana Tenreyro in mid-January, who cited evidence from other countries that negative rates worked effectively. I am less convinced, although the monetary policy effectiveness of negative interest rates would depend crucially on the behavioural response of the banking sector.
When one thinks of the last year, where policy rates in the UK have been cut from 0.75% to 0.1%, but banks have increased the mortgage rate offered to first-time buyers (from around 1.9% to about 3.5%), it shows that the feedthrough of rate changes is far from clear, even when rates are positive. In fact, it is far from clear that negative rates have proved successful in the handful of areas that have implemented them.
Notwithstanding that, by the second half of this year, the economy is expected to be recovering. Thus, even though negative rates may then be in the policy toolkit they will likely not be needed. The BOE, for instance, is expecting the UK economy to grow 5% this year. This is not that upbeat, given the extent to which the economy has contracted, and that previously they had expected 7.5%. Next year they expect 7.25% versus 6.25% previously. This implies the economy will not return to its pre-crisis level until mid-2022.
A change in strategy
While the addition of negative rates to the toolkit attracted much attention, more significant perhaps was that the BOE has shifted stance on its exit strategy. Previously the BOE had said that when it was going to tighten policy the sequence would be to raise interest rates first to 1.5% (although originally under Governor Carney they had said 2%), before then reversing QE. So, rates up, before Quantitative Tightening (QT).
Now, the proposed sequence will be different. It will be QT first, before rates are hiked. This is not just significant, but it also appears to be some way off. That is because the BOE still has many more gilts to buy before reaching its present QE target of £875 billion. It hasn’t yet finished its planned easing.
There have, effectively, been three phases of QE: immediately after the global financial crisis, post the 2016 referendum and during this pandemic. Initially it was planned to be short-lived but QE has remained with us, and like ascending a stairs has continued to rise in stages.
The initial phase saw £200 billion in November 2009, expanded to £375 billion in July 2012. In August 2016 there was an additional, and often seen as unnecessary £50 billion expansion to £425 billion (plus an extra £20 billion of corporate bonds was announced then and has remained at that level since). QE then used to buy gilts was expanded to £625 billion in March 2020, to £725 billion in June 2020 and a further addition to £875 billion was announced last November – in effect a total of £895 billion (£875 billion of gilts and £20 billion of corporate bonds).
So, at their November 2020 meeting the BOE increased their scale of QE by £150 billion. As Deputy Governor Ramsden noted at this February’s press conference, they are adding about £4.4 billion of gilts a week and while they might slow that pace down slightly they are still on track to make the additional gilt purchases by year-end. Thus, as well as adding negative rates to their toolkit in the autumn, the BOE is planning to still be buying gilts then.
According to the BOE’s website, “The aim of QE is simple: by creating this ‘new’ money, we aim to boost spending and investment in the economy.”
Greater QE scrutiny, and appropriately so
QE is coming under greater scrutiny, and rightly so, for two very different reasons. One is that such spending and investment has not been evident as its transmission mechanism – the way in which it works is seen as having done little to help the economy. The transmission mechanism is that it would boost bank lending, boost asset prices and through that there is both a portfolio rebalancing effect and a wealth effect that generates higher spending. The other scrutiny is that it may trigger inflationary pressures, with monetary growth in the UK having risen, as it has done in the US.
Of course, in its defence is the counter-factual, namely what might have happened to jobs and growth if such easing did not occur.
The BOE creates bank reserves and uses this to buy gilts through its Asset Purchase Facility. The Treasury provides full indemnity for this. That is, they underwrite it. The BOE has made money on the gilts it has bought, transferring the money to the Treasury, but in all likelihood money could be lost if QE is reversed.
While this profit and loss is not central to the policy, it highlights the extent to which QE can be considered as a policy to help keep the Government’s cost of borrowing down. Without it, gilt yields would be higher. How much higher, we can’t say because the price discovery element central to any market has effectively been undone in the gilt market because of the scale of the BOE’s buying.
This crisis has also provided further evidence, globally, of the extent to which monetary policy is consistent with fiscal policy across most countries. This is an important consideration.
In the UK and globally, one can view both monetary and fiscal policy during this pandemic as being both unconventional and unlimited. The fiscal policy boost, in particular, has been significant. In early March, there is much conjecture that the Chancellor will raise some taxes and indicate that he favours tightening fiscal policy at the first available opportunity that the economy allows. That is, once the economy has recovered he will tighten.
Clearly, we need to wait and see but the route fiscal policy takes, and in turn how the economy reacts, will have a bearing on the path of monetary policy, too. In short, the more the Chancellor tightens fiscal policy, the more likely it is that that the markets will conclude that monetary tightening will be delayed.
Thus, it seems appropriate to expect policy rates to remain at a low level for some time.
Please note, the value of your investments can go down as well as up.
