Options for QE exit
Exchanging UK government bonds
by Meghnad Desai and David Marsh
Fri 4 Jul 2014
Except for the European Central Bank (ECB), everyone agrees that quantitative easing (QE) has more or less run its course. Both the US Federal Reserve and the Bank of England are thinking up various ways of signalling a reversal in interest rates. The Bank of England would be well advised to consider a novel way of engineering such an outcome – through the transfer back to the UK Treasury, and subsequent cancellation and conversion, of the £375bn worth of government paper the Bank has acquired under QE.
In putting forward this new variation on a theme that has already occupied some attention, we recognise that, with the reversal of QE (just as in the advance into it), central banks are in uncharted territory. No one knows what the long-term effects on the transmission of money and on the economy will be either of the large increase in central banks’ balance sheets ensuing from crisis-fighting measures since 2008, or of the likely reduction in the next few years.
The optimal size and shape of central banks’ balance sheets, their appropriate asset-liability mix and the nature of their capital backing are all subjects where there are many questions and few answers. The proposal that we put forward is one of a range of options that could be considered. This is part of a series of reflections that OMFIF will be putting forward in the next few weeks regarding the present and future structure of central banks’ balance sheets.
One method already under consideration for reshaping central banking balance sheets would be for the Fed and the Bank to sell government bonds they have acquired back to the market in an orderly fashion and watch the impact on bond yields feed through to other interest rates. That would produce a monetary contraction. The ECB has already started to reduce its balance sheet in such a way, as banks have repaid large amounts of the special long-term loans the ECB extended under its LTRO programme of December 2011.
In view of the slow pace of European recovery and the danger of deflation in the euro area, the ECB has announced another more targeted loan operation which, depending on how much is actually implemented, will further inflate its balance sheet. The ECB has not totally ruled out recourse to full-scale QE at some later stage – but this is starting to look improbable, given the implacable opposition of both the German finance ministry and the Bundesbank.
There are other ways for the Bank of England to reverse direction, for example through adjusting reserve requirements and adjusting or reversing the repurchase mechanism under which central banks make loans to banks against collateral.
Our plan represents a different way of thinking about exit. The Bank is owned by the UK government. Now that QE in the UK has come to an end, the £375bn of government debt in the Bank’s hands amounts to slightly more than a quarter of the total debt of around £1.3tn. Thus one part of UK plc owns the debt of another part and receives interest payments which are a burden on the national budget.
While the Biblical injunction is that the right and left hands should not know what they are doing, practising this in the field of national finance is not sensible. The Treasury should be able to ask the Bank to surrender the £375bn of bonds and then cancel them. As the Treasury paid £48bn in interest payments last year, we can estimate a saving of around 25% or £12bn – the exact number will depend on the details of the bonds bought back. The net saving would actually be less than this, at around £4bn since two-thirds of the Bank's profit each year is paid to the Treasury in lieu of taxation and dividend. But even £4bn would bring some relief to George Osborne, the chancellor. It might even be used for a tax cut.
There is a complication, since the Bank has liabilities corresponding to the assets purchased. The Bank has printed money (or issued e-money) and this resides on the liabilities side of the balance sheet as the counterweight to the bonds purchased. The bonds cannot simply be cancelled to put an end to the matter, since this would result in a straightforward loss to the Bank, like any defaulted loan on a commercial bank’s balance sheet. The size of the cancellation far exceeds the Bank’s capital and reserves. This would put the Bank into a position of negative equity which would have a damaging effect on confidence.
The Treasury could in principle offer an equivalent amount in zero coupon bonds to the Bank to balance the books. These bonds need never be marketed but just stay on the books to balance them. It may even be that the amount of zero coupon bonds the Treasury may need to issue may exceed the £375bn. The total debt will either be reduced by £375bn if the bonds are cancelled or stay the same, or perhaps rise a little. If the debt is reduced, this should ease the pressure on the Treasury. If it stays the same or even goes up slightly after replacement of the cancelled bonds by zero coupon bonds, the interest saving is perpetual. This eases the fiscal burden.
How will the markets react? Will they treat this transaction as a sign of worse to come, as irresponsible public borrowing, or will they see the sense of this move? The monetarists used to tell us that the deficit must not be monetised, printing presses must not be run to finance public spending. But Ben Bernanke at the Federal Reserve reversed the wisdom of that adage and decided that buying government bonds by printing money was the whizz solution to the recession. Thus the money is already out there. What is more it is staying in the corporate coffers and not flooding the economy.
The money that is out there needs to be transmitted into economic activity. If the Bank were to hand over the £375bn worth of assets to the Treasury in return for an equivalent amount, the outcome could be that nothing will change. The Government at present pays interest to the Bank and gets it back in some form. Instead it would not have to pay it out at all.
The risk of this approach is that interest rates could rise uncontrollably if investors lost confidence in government bonds, so the strategy would have to be handled with great care. But a view that interest rates are about to rise could prompt companies to begin unloading their cash. That may be helpful in generating a further boost to economic activity.
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