Wednesday, July 15, 2009

Questions for the Deputy Governor of the BoE

I have long been arguing that the Bank of England's purchase of gilts with printed money (so called quantitative easing - QE), has supported the UK bond market and that the Bank of England has effectively been monetizing the debt of the UK government. In my most recent post on the subject, I identified that overseas holders were selling gilts to the Bank of England, and that QE was supporting prices. In a slightly earlier post, I showed how the Bank of England rationale for QE made no sense whatsoever, and that it was just a cover for propping up the massive UK fiscal deficits. My criticisms of the policy date back to before it was even enacted, and I even predicted that it might be enacted as the fiscal situation deteriorated.

The fig leaf for such monetization has been that the action has been taken to prevent deflation. However, it is only now that the CPI measure of inflation that is targeted by the Bank of England has finally fallen below the target of 2%. Even now, it is just undershooting slightly at 1.8%. Even at slightly below target, it is difficult to see why such a radical policy of QE might be justified, as such a level does not even require a letter of explanation to be written.

I have returned to this well worn subject as yet more evidence of the necessity of QE to support gilt prices has emerged. In an earlier post I speculated that the Bank of England might be losing patience with the government's fiscal incontinence, and they have recently put on hold the possibility of extending QE beyond the original £125 billion of the original policy. The result is reported in the following from Reuters:
Government bonds tumbled on Thursday, propelling 10-year yields almost a fifth of a point higher after the Bank of England announced no increase to its quantitative easing programme.

With the economy still reeling after its sharpest contraction in more than 50 years, markets had widely expected the central bank to increase its asset purchases by 25 billion pounds.

Traders fretted that its decision to leave the target unchanged meant the Bank's unprecedented scheme to buy assets, over 90 percent of which have been gilts, may soon be brought to an end.

Ian Kernohan, an economist at Royal London Asset Management, said the knee-jerk rise in gilt yields gave some indication of the size of the QE premium in gilt prices.

"The problem will be how to exit the QE strategy without causing a significant back up in yields and the cost of funding the government's deficit," he said.

The September gilt future settled 1.45 points lower, sharply underperforming the equivalent Bund future which fell just 24 ticks.

The key part of this article is that the fall was not as a result of the Bank of England stopping QE, but as a result of no announcement of an increase in the QE programme. As some of the analysts described it, it appears that there was a belief that it was just a delay in the announcement of an extension of the programme:

Some analysts saw this as a hint an extension to the programme had merely been delayed until next month, when it will be able to explain its actions more fully.

"This probably does not sound the death knell for QE," said Philip Shaw, chief economist at Investec. "Rather we expect an increase next month, when the monetary policy committee will have the benefit of a fresh set of inflation projections," he added. The Bank indicated that it would slow the pace of its gilt purchases, buying just 4.5 billion pounds of gilts next week. Since April, the central bank has been buying gilts at a rate of 6.5 billion pounds a week - roughly double the rate at which the government has been issuing them.

It is apparent that even a hint towards an ending of QE is enough to set the markets on edge. The result is that Charles Bean of the Bank of England has since needed to offer hope to the markets by saying the following:

"We haven't paused on QE. We are committed to buying 125 billion pounds of assets that will take us through to August," he was quoted as saying.

"We decided last week there was no need to make a firm decision. and we could afford to wait. August is when we publish papers on the economy and it's a natural point at which to take stock."
It is apparent that the state of the gilts market is now largely being determined by Bank of England purchases, and this really is the monetization of debt that I have long considered to be the result of the QE policy. The fragility of the gilt market, and the necessity for QE to support the market have been revealed.

One of my regular readers has identified that Charles Bean is taking questions on the policy of QE and suggested that I ask him some questions about QE. At this stage, this seems the best way of seeing how the Bank of England might justify the policy. As such, I have sent the following questions.
1. Reuters has reported on the 9th July that, following no announcement of an extension of the policy of QE by the Bank of England, bond yields rose sharply. Bearing in mind that just the possibility of an end to the policy caused this reaction, does this not suggest to you that QE is propping up the Bond Market?

2. The CPI has finally dipped below the 2% target that the Bank of England uses in setting monetary policy, but is still not far enough off target to require a letter of explanation. I believe that the Governor of the Bank of England has identified QE as an untried unconventional policy with uncertain outcomes. Bearing in mind that, during all but the last week, CPI has not fallen below target, how can such an untested policy be justified? In particular, with monetary stability as a key aim, how can such an unconventional policy be justified?

3. With regards to exit strategies for QE, the Bank of England Quarterly Bulletin for 2009 Q2 states that 'Alternatively, the supply of reserves could be reduced without asset sales, through the issuance of short-term Bank of England bills.' Is this policy? If so, can you confirm exactly when and under what circumstances you will finally sell the gilts that have been purchased?

4. A secondary question as a follow on to question 3. If the purpose of QE is not to monetize government debt, then why would you not sell gilts at the end of QE policy? Do you have concerns that the existing expansion of gilt issuance would preclude the sale as the sale might destabilise the gilt market? Is this not recognition that the gilt market can not support the current level of issuance?
I do not know whether I will get answers, but it is certainly worth asking the questions. I will update you on any reply that is made. In the meantime, it is apparent that the Bank of England is locked into QE if it does not want a collapse in the gilt market. They are faced with the tough choice of supporting government irresponsibility, or seeing a gilt market collapse and the resultant fallout for the £GB. On the other hand, if they continue, the situation can only get worse, as the economy slides further down, and government borrowing continues to climb.

It is a tough position to be in. However, I hope that they might conclude that it is better to face the problem now rather than later, at which point it can only be far worse.


  1. "It is a tough position to be in. However, I hope that they might conclude that it is better to face the problem now rather than later, at which point it can only be far worse."

    Frank Field MP on the BBC's 'Any Questions' a couple of weeks ago said something along the lines of ...

    "my big worry at the moment is that no major political party is prepared to grasp the nettle of spending cuts. While this goes on the economic situation is continually deterioating and uncertainty is gaining. This means that one day a massive currency crisis, or similar, will seem to come from nowhere. It will be at the weekend where the gov will be forced to make massive spending cuts in order to placate the City before the Monday morning opening. These spending cuts will be a lot deeper than necessary in order to placate the fear of collapse that will be prevalent at the time."

    While more recently a pundit commenting about the economy said that we were in no-man's land until the general election.

    So, the further away the election the more serious the inevitable crisis.

  2. I took note of the comments on the Disqus comments system and have reverted to the original blogger system. If there are any glitches, please let me know.

  3. We all know what will happen - either the BoE stops QE, causing a funding/currency crisis, or the BOE continues QE ad infinitum causing a Zimbabwe style economic meltdown.

    The only alternative is big spending cuts (bigger than anything ever managed before, even by the evil Tories in the 80s) and big tax rises NOW. That would bring the budget back to some semblance of balance and allow QE to be ended, and whatever deficit remainded to be funded at a reasonable interest rate.

    The longer we wait before dealing with it increases the likelihood of a crisis happening first. Then the cuts/taxes will need to be deeper/higher than they would be now.

    The whole thing is a complete mess. I blame socialism. Spending someone else's money is always easier than earning your own. I always predicted the socialists would ruin this country, and sadly, I was right.

  4. Reply to Sobers

    The whole thing is a complete mess. I blame socialism. Spending someone else's money is always easier than earning your own. I always predicted the socialists would ruin this country, and sadly, I was right.

    Curious that you blame "socialism," even though anything resembling Bretton Woods era socialism has been dismantled a long time ago, and we have had 30 years of neo-liberalism and globalization.

    Whatever happened to Thatcher's deregulation and privatisation, in your scheme of things?

    Moreover, British manufacturing began to collapse under Thatcher, because of her idiotic "monetarism" that caused the worst recession in Britain's post war history and that gutted industry:

    Britain lost approximately 25% of its manufacturing production capacity in 1979-1981, making the nation ever more dependent upon the provision of services. Had not North Sea oil and gas supplies increased by more than 70% during this period, it is hard to see how the government could have avoided bankruptcy.

    Eric J. Evans, Thatcher and Thatcherism, Routledge, London and New York, 1997.

    And for some reason socialism gets the blame for all this.

  5. Counterpunch has a good article by Paul Craig Roberts on the state of the US economy:

    What Economy? There's Nothing Left to Recover

  6. @Lord Keynes: I think that at the height of Thatcherism the State still spent about a third of GDP. We will be well over 50% soon. If thats not socialism I don't know what is. The State now controls more of our lives than ever before, both financially and legally via its restrictions of our freedoms. We are one of the most controlled populations outside a few tinpot dictatorships. There are more laws banning things and controlling what we do, or say, or even think, than ever before. That is all down to socialism. The concept that the collective is more important than the individual. The idea that it is better for all to be poor than some to be richer than others. The idea that the State deserves to have 50% of the fruits of your labours. The splitting of society into factions based on gender, race and sexual orientation.

    These are all socialist concepts and are ruining our nation. The current financial ruin is just the icing on the cake. Not only will we be under the socialists ideological yoke, we will all be grindingly poor as well. What a great future awaits. Sadly 1984 and Atlas Shrugged were written in vain.


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