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The transcript for ICAEW Insights In Focus podcast episode 39: 'How will quantitative tightening affect the UK economy?'.

Philippa Lamb: Hello and welcome to the ICAEW Insights In Focus Podcast. I’m Philippa Lamb and today we’re discussing what the Bank of England’s reversal of quantitative easing will mean for the economy and government finances. With me to discuss that I have Ruben Wales, ICAEW Head of Financial Services, Martin Wheatcroft, external adviser on public finances to ICAEW and Michael Saunders, an economist who sat on the Bank of England’s Monetary Policy Committee (MPC) for six years – from 2016 until very recently.

It is hard to believe now, but when the Bank of England introduced QE in 2009, it was an unprecedented move. Since then, the policy has played into a decade of economic stability, reducing the impact of upheavals including the financial crisis, the Brexit vote and, of course, the pandemic. But fast forward 13 years to right now and the central bank has a new parallel challenge – how to undo £895bn worth of monetary stimulus at a time of financial volatility.

So, Reuben, I know QE has become part of our shared vocabulary but before we get started, shall we recap? What is it exactly? How does it work?

Reuben Wales: Quantitative easing is effectively where the Bank of England or central bank acquires government debt from the secondary market. So in the UK, that would typically be gilts. It does this through the creation of new central bank deposits with commercial banks and in effect, through that, creates new money supply that commercial banks can use to provide liquidity to the banking system. It was thought that, through this intervention, additional monetary supply combined with lower interest rates would spur lending activity between banks to the real economy – consumers and businesses – and act as a counter to the recessionary pressures that were existing at the time when this was implemented.

PL: Martin, how does it work from an accounting perspective?

Martin Wheatcroft: Well, the accounting starts quite simply, but then gets pretty complicated as we build up the position for the overall public finances, especially as the government makes it really difficult by using two different types of accounting. So the accounting under IFRS, or International Financial Reporting Standards, is what I’m going to talk about first, and then the fiscal numbers used in the budget. Under IFRS, you have debt that is issued – gilts – and if you were to issue £105m of gilts at a nominal value or redemption value of £100m, that would be a premium of £5m. And you would amortise that debt, that £5m, over the life of the gilts so that you get a constant interest rate in your accounts when combined with the coupons that you pay to gilt investors. And that’s how most companies would account for debt that they issue – that’s similar to a government bond. But then you have the Bank of England come along. Its asset purchase facility – a special purpose vehicle – comes along, buys the gilts and replaces them with newly created money – central bank deposits, and if it, say, pays £110m for those gilts, you’ve got a difference between what it paid and the carrying value of those gilts, which for the sake of my example, I’m going to assume has amortised down to £103m. So you’ve got a £7m difference. And that is a finance charge and extinguishment of debt charge, because from an overall picture, the government now has central bank deposits in place of the original fixed-rate gilts that it issued. That has the effect of an interest rate swap: the government now is paying bank base rate on those bank deposits instead of the fixed rate it would have based on, and when interest rates were low, the government was saving a lot of money, and the Bank of England was actually repaying the Treasury money. But now that’s reversed and the Treasury is having to compensate the Bank of England for the extra money it’s having to pay out on the bank deposits.

In the fiscal numbers, you get a slightly different answer because the government reports debt at nominal values, at the redemption values. And so that original £5m premium that I used as an example, that would be recorded as a financial transaction outside receipts and expenditure. We would have recorded just a liability of £100m and we would have an interest charge equal to the coupons that we’re paying on the debt.

But when we come to QE, we get the same thing: Bank of England comes along, pays £110m, and we now have to record a higher amount in the fiscal numbers, the numbers used in the budget and in the national accounts – the accounting is slightly different. The debt is recorded at nominal value, the redemption value, and so that £5m premium that we had in the original example, that is removed, it goes through financial transactions outside receipts and expenditure. So it doesn’t hit the deficit and is not recorded as part of the interest charge, which is basically now just charged as equal to the coupons that are paid on the gilts. And when the Bank of England comes along and buys those gilts, it’s paying £110m for something that’s recorded in the books at £100m. And so the £10m also gets recorded outside the deficit, and you get a higher debt number which, in the fiscal books, is reported as an incremental £10m, with the original gilts still recorded as a liability, even though they are an internal government liability now owed from one part of the public sector to another. That’s the position before we get to quantitative tightening.

PL: Michael, you’re a long-term QE watcher, you were on the MPC until very recently, so what is your thinking about what the thinking was when QE was first introduced?

Michael Saunders: The Bank of England’s Monetary Policy Committee, of which I was a member, is responsible for setting monetary policy to return inflation to the 2% target over time; we want to avoid high inflation. I’m sure your listeners don’t need reminding of the costs of high inflation – we saw them in the 70s. Low inflation, below the 2% target on a sustained basis, is also a bad thing. It’s usually associated with high unemployment and incomes foregone. So returning inflation to the 2% target helps to underpin economic stability and long-term growth prospects. The main tool for setting monetary policy is interest rates. So we’ve seen this year, for example, the MPC raising bank rate steadily from close to zero to 3% now. But what do you do if you cut bank rate as far as you think you can cut it, and you still face a prospective inflation undershoot, and you want to provide more of a boost to the economy? That was the situation which the MPC faced in early 2009. Bank rate was close to zero; they didn’t think the banking system could cope with a zero or negative interest rate. So QE was the additional policy tool for stimulus when you can’t cut interest rates further, when bank rate is at the effective lower bound. By buying gilts they lower gilt yields, that lowers long-term borrowing costs for households and companies, boosts growth, boosts investment, boosts jobs, helps to prevent a sustained inflation undershoot. That policy having been launched in 2009, there was a further wave of QE in 2012 during the Euro area crisis, another one in 2016 when the Brexit vote threatened to press the economy, and substantial further amounts of QE during the pandemic when, of course, the economy was shut down and there were risks of a sort of vicious circle of companies cutting back on jobs and investment in a major way.

PL: You weren’t on the MPC at the time when it was first introduced. I don’t know if you recall what the vote was – and would you have voted for it yourself?

MS: Oh, of course, I think the decision to launch QE in 2009 was completely the right thing. The vote was unanimous, I think, and the successive waves of QE since then, have all been endorsed by heavy majorities for the QE. I’ve been involved in the most recent ones during the pandemic. And it’s worth thinking about how the economy would have looked if we had cut interest rates to their effective lower bound, still faced prospective economic weakness, and the MPC had not been able to loosen further. Then we would probably have had a much more depressed period in terms of jobs, incomes and investment, and I think that would have hurt many people.

PL: Would it be fair to say that QE has gone on longer than perhaps was initially envisaged, due to events that you’ve outlined? I don’t imagine they thought it was going to go on for quite this long, did they?

MS: I think that’s fair. You know, back when QE was originally launched in 2009, I don’t think people expected that the economy would be weak for so long. The thinking then at the time was that the economy would rebound faster. I think the experience of that period shows you it’s very hard to recover quickly from debt-driven downturns, which the Great Recession of 2008/09 was; and also the Euro area crisis was an ongoing headwind for the UK in 2011, 2012, and 2013. So the economy has needed support several times over a sustained period and that’s why QE has gone on for so long.

PL: £895bn – it’s a big number. Can you put it in perspective for us from the bank’s point of view?

MS: If you were to think about the broad fiscal effects of QE – Martin has talked very well about the direct effects – that the government was sort of making running yield profit when bank rate was very low and lower than the yield on the gilts that they bought, and is now going to face a running yield loss as bank rate goes up. And so the interest costs on those bank reserves rise and the Bank of England may well face some mark to market losses on some of the gilts it bought. But there are broader fiscal effects which are undoubtably significantly positive. The government over the last 14-15 years has issued £2,300bn worth of gilts. And it’s probably been able to issue those gilts at a lower yield than it would have done had QE not occurred, and tax revenues have been boosted because QE has lifted economic growth. Now, estimates of the positive effects on the fiscal position from those channels, those indirect effects, are uncertain. But it’s quite easy to produce plausible estimates that those positive fiscal effects have been worth several £100bn since QE was launched. And so I suspect, even though we face mark to market losses, that the net effect of QE on the public finances probably has been and will continue to be significantly positive.

PL: What proportion of government debt does the bank now hold?

MS: My answer would be 30 to 40%.

MW: It is 30 to 40%, yes. Just adding to what Michael said, my perspective on QE is that it was a very big interest rate swap. So it swapped fixed-rate debt for variable-rate debt linked to the bank base rate. That has had two benefits. I think, as Michael was saying, firstly QE – by reducing yields – has enabled the government to borrow much more cheaply over the longer term. But overlaid on that, QE is also an interest rate swap, and has switched this whole chunk of debt from fixed rate to variable rate. And that increases the exposure of the public finances to movements in interest rates. And as interest rates have risen, that’s hit the public finances much more rapidly than it would if you’d been able to embed all that low interest rate for longer periods.

MS: I think that point about the increased sensitivity of government debt to changes in bank rates, short-term rates, is a really important one. So in thinking about what’s the long-term future of these gilts which the Bank of England has bought, there would be one option: they just leave them on the balance sheet, and they mature in 10, 20, 30, 50 years’ time. But the adverse effects of that would mean that the government would persistently have a relatively high public debt exposure to changes in short-term interest rates. Now, the UK has a very long maturity of its debt. And I think it does that for a sensible reason: in order to ensure the public finances are not heavily exposed to changes in short-term interest rates. So to me, one of the reasons why you would over time want to unwind those QE purchases – to do what is now called quantitative tightening, the selling of those gilts – is to ensure that the maturity profile of public debt, its exposure to short-term interest rates, sort of gets back to where we would want it to be.

MW: Yes, definitely,

PL: So Martin, what are your thoughts about the overall impact on the government’s finances in the last decade?

MW: Over the last 12 years or so quantitative easing has really benefited the public finances, it’s cut interest costs in particular. But that’s at a time where we’ve had debt building up and an increased exposure to debt. So when QE started originally, overall government debt was relatively low. But we have been borrowing an awful lot over the last 12-15 years and we’ve seen debt go up. And we’re on course now according to the OBR, to hit about £3trn of debt by 2028. So it continues to grow. Some of that benefit is now starting to unwind. We’ve now got Bank of England base rates that are higher than the coupons, than we were paying on the gilts. And that means that Treasury is having to compensate the Bank of England in order to pay that higher interest rate on the QE balances.

PL: I wanted to ask Reuben about that, actually, because things have been more volatile recently. We had the Autumn Statement last week, we had the Truss/Kwarteng mini Budget spooking investors before that – where would you say the government finances are now?

RW: As Michael and Martin have alluded to, as a result of QE we are more exposed – or our public finances are more exposed – to movements in the yields on gilts. And of course, we’re all quite familiar now with the impact of the fiscal event, which did result in much higher yields on medium and long dated gilts. If that situation had held – thankfully, it didn’t – of course, there would have been much higher interest rates passed through on central bank reserves, as the bank may have responded to that environment by raising rates faster and further than they otherwise would have. And also, of course, as we’ve referred to, the impact that may have had on the mark to market valuation of those gilts. Thankfully, the Bank of England stepped in, in September and October, to address the issues within the gilt market. And we’ve now had an autumn Budget that for the most part returns to fiscal orthodoxy. The markets responded well to that and gilt yields have returned somewhat. I guess the thing to note here is that, of course, as we continue to try and address inflation, interest rates will continue to rise. And that is where the additional cost to public finances will come in from QE.

PL: So we have now QT – quantitative tightening. Let’s just be explicit about that. Why do you think right now is the moment that this is happening?

RW: Well, as we know, inflation is currently at around 11% and the Bank of England has made strides already to increase interest rates in response to that situation. Quantitative tightening is clearly the reversal of what we’ve had over the last 13 years, where the Bank will look to unload gilts into the market and, where they are naturally maturing, not replace them. So it’s an exit of an effort that supports high interest rates, and it is reducing money supply. And as a consequence, we hope it will support the efforts to lower inflation.

MS: I would say that the driving force behind the decision to unwind QE, and to start to implement QT, is that the Bank of England doesn’t want to have a large – very large – balance sheet, a very large stock of QE, indefinitely. And that’s partly for the reasons for ensuring the public finances aren’t overexposed to changes in short-term rates that we described previously. The Bank of England viewed the QT as likely to be only a pretty modest tightening of monetary policy. So they don’t really view it as a key monetary policy tool. Bank rate is the main monetary policy tool, and QT is likely to sort of chug along in the background – hopefully, as a low-drama exercise. The Bank is not seeking to use QT as the active policy instrument. So the way in which they’ve set QT is to aim to do a certain amount each year. And that will, they would expect, proceed more or less regardless of what’s happening to the economic data and the state of the economy. Whereas obviously, decisions on bank rate, which is the active policy tool, are made frequently throughout the year.

PL: Is there also a thought that the bank doesn’t want to look like it’s lost its independence, holding so much government debt, and it’s directly financing government borrowing? That’s an odd position for it to be in surely with I think you said 30 to 40% government debt?

MS: QE has never directly financed government borrowing. That’s a really important point. Because often people allege that the Bank of England is just financing the government. It’s not to do with that; the government has always issued its debt into the market. And the Bank of England has never bought debts directly from the government; it has always bought debts in the secondary markets, from private investors. So that has helped to keep gilt yields low. Undoubtedly, that has provided more favourable borrowing costs for the government, but I have to say that is not the chief motivation. The chief motivation is lower borrowing costs for households and businesses, because that is what’s given a boost to the economy over the last 15 years. And there have been times when the economy has really badly needed that boost.

MW: Just to add to that, I think one of the helpful things to think about with the accounting is that QE has been just a swap between different types of debt from a government finances point of view. It had fixed-rate gilts; it then post-QE has variable-rate central bank deposits – both different types of debt. So the idea that it’s been financing government is strange. It may seem to some people as if that’s what’s been happening, but in reality, government has gone to private investors and raised money, and then the Bank of England has swapped it into a different type of debt.

MS: You can see the difference really, actually, in the course of this last year. After all, the government is still borrowing quite a lot – more than it had expected a year ago. And the Bank of England is not buying bonds to help the government out; it’s selling bonds, because it’s seeking to reduce the balance sheet long term. And after all, it is in a monetary policy tightening cycle. So when the economy is weak, and bank rate is at rock bottom, that’s when QE becomes an active policy tool for stimulus. On other occasions, I would expect the Bank of England to be gradually seeking to run down the balance sheet.

PL: Yes, it’s dipped its toe in the water, hasn’t it, so far as it’s sold about £750m worth of bonds so far – is that right?

MS: Well, the process has only just started. So they’ve laid out an aim of seeking to reduce the stock of QE by £80bn over the course of a year. Roughly half of that, in other words about £40bn, should occur naturally through the redemption of bonds which are held by the Bank of England, and the other half – the other £40bn, would be through active sales. And those have only just started. Their aim is to just sell modest amounts steadily, not seeking to disrupt markets, not seeking to push gilt yields higher. This is something which should be, hopefully, the financial market equivalent of watching paint dry.

PL: Risks associated with QT – do you see any?

MS: There’s an element of it, which is unknown. The UK hasn’t sought to unwind QE previously; the Fed has unwound part of its QE programme – they had an equivalent asset purchase programme. But they’ve done it really through the redemption of maturing bonds, rather than actually selling bonds in the market. The Fed’s bond holdings are a much shorter maturity than the Bank of England’s, and so many more of them mature naturally, from month to month, year to year. So they have been doing a substantial amount of QE unwind in this sort of passive way.

PL: But this is new for us?

MS: Actually selling the bonds is a new step. And that’s the reason why the Bank of England, correctly, I think, decided to proceed fairly gradually and cautiously, not seeking to make that a big drama.

RW: We might see risks that we didn’t otherwise or previously consider to be a significant risk, as we have had in now the recent past the dislocation in gilt markets, where yields have spiked and where we’ve seen – instead of, what was commonly thought of as an asset class that you ran to – investors run away from [it], so while that wasn’t to do with quantitative easing, or indeed quantitative tightening, that risk does remain within that market. It is now more vulnerable than it was in the past. And so I guess, as you say, softly softly is probably the right approach, because we will be looking at a situation where the Bank of England is unloading gilts and similarly, the government will be issuing new gilts as a part of covering deficits. And so it’s the extent to which the market can absorb that kind of supply of gilts – that remains the question for me.

MS: I think the really important point that comes out of that is the UK at all times, through government actions and Bank of England actions, needs to ensure that it acts in a way which underpins the credibility of our medium-term economic framework – that the public finances are on a sustainable path and that inflation will get back to target. We have seen – and we don’t need reminding of this, but Liz Truss clearly did – that that’s the kind of risk which can happen if the government’s macroeconomic credibility starts to be threatened. We want to avoid that.

MW: I was going to add that we’ve talked about the risks on interest rates and so on, but I think the biggest risk does come down to what it means for the public finances more generally, and in terms of tax policy and public spending policy. Regaining that credibility has been hugely important, because that enables the government to continue to borrow substantial sums. So if you’re asking what the risks are, I would say the risks are that you end up with higher taxes or further cuts to public services in order to ensure the public finances are credible from a market perspective. And that’s a real risk.

PL: So it’s QT for now; might we see QE again, in the future?

MS: QE is in the Bank of England’s policy toolkit. So at the moment bank rate is 3%. My expectation is it will go higher in the next few months. I’m not sure exactly where the ceiling is; I wouldn’t be surprised if we get to 4% in the next six months or so. And there are risks that we could go higher than that. If one thinks over the medium-term future – not the next year or two, but the next five, 10, 15 years – if there is another crisis and inflation threatens to undershoot, we face high unemployment and the bank rate has to be cut down to zero or even slightly negative, to a level at which it cannot go further, then QE will be back on the table. Hopefully that kind of situation won’t arise. But if needed, QE is there as a policy option.

RW: I guess the main caveat to that is that we assume that inflation is under control. We wouldn’t necessarily want a situation where we were introducing QE when that wasn’t the case.

MS: Exactly – that’s a very important constraint; QE is a monetary policy tool voted on by the Monetary Policy Committee that is tasked with ensuring that inflation returns to the 2% target. So if we’re in a condition in which inflation is high – and it’s above target now, well above target – and bank rate is well above zero, you would not expect QE to be happening under those conditions. It’s only a tool for trying to boost a depressed economy, when we otherwise face a sustained undershoot of the inflation target, persistent high unemployment and job losses. It’s for those kinds of dire situations that QE is in the toolkit.

MW: The rather unfortunate thing is we’ve had two of those occasions in recent times.

MS: And that’s why it’s important that QE is available. Even if you hope the situation won’t arise in which you use it, it’s there if needed.

PL: I think we have to leave that there. Reuben, Martin, Michael, thank you very much – a really interesting discussion. The next Insights In Focus podcast will be out in early December, and we’ll be discussing the finer points of the Economic Crime Bill currently passing through parliament. The next Insights podcast, when we’ll be looking back at some of 2022’s most significant business and economic events, will air later that month. In the meantime, please rate, review and share this episode and subscribe to ICAEW Insights wherever you get your podcasts