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.