By Andy Bruce
LONDON (Reuters) – Under pressure to act against surging inflation, the Bank of England looks ready to explain how it will reduce the vast pile of British government bonds it has bought over the last decade in repeated attempts to stimulate the economy.
Most economists polled by Reuters think the BoE will on Thursday raise interest rates to 0.5% — the threshold at which it has said it will start unwinding its 895 billion pound ($1.2 trillion) quantitative easing programme. [ECILT/GB]
The BoE has bought 875 billion pounds of British government bonds – or gilts – from investors, financed by the creation of new bank reserves paid into the seller’s bank account. It has also bought about 20 billion pounds of corporate bonds.
The gilt purchases helped to lower the cost of government borrowing and left investors free to buy other assets like shares and corporate debt – in theory helping to lower the cost of credit across the wider economy.
The BoE now owns more than half the standard, non-inflation-linked gilts in existence. When the government boosted debt issuance to cover the costs of the COVID-19 pandemic, its holdings moved in step, which some lawmakers said risked compromising the BoE’s independence.
With consumer price inflation hitting an almost 30-year high of 5.4% in December, BoE rate-setters are keen to show they are in control of monetary policy.
They see unwinding this stimulus, a process economists call quantitative tightening (QT), as a chance to do that.
WHAT IS QT?
Quantitative tightening is the reverse of quantitative easing. Instead of expanding or maintaining the 875 billion pounds of the bank reserves issued by the BoE to buy gilts, QT means reducing this figure.
HOW WILL IT GO ABOUT QT?
The BoE has said it will start with “passive” QT when interest rates rise to 0.5%. This means the BoE will not actively sell its gilts back to investors, but will instead hold them until they mature.
In the past the BoE used the proceeds of maturing bonds to buy replacements, maintaining the level of its asset purchases. Under passive QT it would cease reinvestment and instead eliminate reserves, in the same way they were created for QE.
This process could start in March, when the 4% 2022 gilt – of which the BoE owns 25 billion pounds – is due to mature.
“Initially, it will simply amount to a large, predictable and recurrent buyer not turning up to buy gilts,” said ING economists Antoine Bouvet and James Smith.
A purely passive approach to QT would see gilt holdings fall to around 435 billion pounds in 2031 – similar to their pre-pandemic level, according to Reuters calculations.
WHAT ABOUT ACTIVE QT?
If all goes smoothly, the BoE might decide it can start to sell small portions of its gilts holdings back to private sector investors on a regular basis.
Last August the BoE said it would begin to sell gilts “only once Bank Rate has risen to at least 1%, and depending on economic circumstances at the time”.
“We expect the BoE to also begin active sales in November at an initial pace of 5 billion pounds. In our view, QT will substitute for some Bank Rate hikes,” said Robert Wood, economist at Bank of America (NYSE:BAC).
ARE OTHER CENTRAL BANKS DOING QT?
In 2017 the U.S. Federal Reserve began to allow its U.S. Treasury bond holdings to mature without being fully reinvested, but the COVID-19 pandemic prompted a renewed expansion of QE.
Minutes from the Fed’s December meeting showed officials had discussed again shrinking the U.S. central bank’s overall asset holdings as well as raising interest rates sooner than previously expected to fight inflation.
HOW MANY GILTS WILL THE BOE SELL IN TOTAL?
The BoE has given little indication of how much it wants to reduce its holding of gilts, but has said that it expects its total balance sheet – which includes the gilts – to be “materially larger” than before the 2008 financial crisis and some way below its level in 2021.
WHAT ARE THE RISKS?
As no central bank has attempted QT over a prolonged period, the BoE looks likely to start out cautiously to see how the gilt market, other asset prices and the economy react.
Given the precise effects of QE are still debated by economists after more than a decade, opinion varies over the likely consequences of the policy’s reversal.
“The consensus view is QT will mean higher yields and a steeper curve, amidst concerns about who will step in to buy all the gilts. We disagree,” HSBC economists and strategists said.
“Some near-term volatility is possible as valuations adjust to any announcement. But provided QT is clearly communicated and is predictable, we see little or no direct trade-off between the balance sheet and rate hikes.”
There are some potential tail risks, economists say.
A major, sustained reduction in gilt prices would reduce the value of the remaining gilts held by the BoE and potentially lumber the central bank with hefty losses on paper, which in an extreme scenario might require the taxpayer to step in and recapitalise the British central bank.
($1 = 0.7421 pounds)