Quantitative easing: The shocking truth.
Don’t know your standard monetary policy from the unconventional kind? Relax! We ask economist and former Bank of England adviser Tony Yates all those questions about QE (and its seldom-seen friend QT) that you always wanted the answer to but never dared put.
Presented by Jonathan Ford and Neil Collins.
With Tony Yates.
Produced and edited by Nick Hilton for Podot.
Jonathan Ford 00:06
Hello and welcome to a long time in finance with Jonathan Ford and Neil Collins, in partnership with briefcase dot news, the service that brings intelligent curation and analysis to your media monitoring. Since March 2009, the Bank of England has purchased about 850 billion of UK government bonds and a few other bonds. The objective, at least initially, was to stabilise the banks following the financial crisis when they took huge losses by giving an assurance to customers and investors that they were not about to run out of cash. Also to keep interest rates low to encourage people to invest in riskier assets and get the economy moving. The idea was never for the Bank of England to start directly financing government expenditure or printing money like the Reichsbank in Weimar Germany. But QE carried on long after the crisis receded, and more than 50% of cumulative bond purchases have taken place since March 2020. Now, to many of us, QE is a bit difficult to understand, it all sounds a bit like the magic money tree might have sprouted in the governor’s garden in Threadneedle Street. But is it? So we thought we get along and expert to tell us. Tony Yates is an independent economist and former adviser to the Bank of England’s Monetary Policy Committee. What he doesn’t know about QE can be written on the back of the world’s smallest non-fungible token. So welcome, Tony.
Tony Yates 01:31
Thanks very much.
Neil Collins 01:32
I know that I know that you know, a lot more than we do about this stuff. But let’s start with the basics. Because I think we just need to set out how QE works and how it’s meant to work. Maybe we will actually start with what happens when the Bank of England buys a gilt from a bank. And what does that bank get in return?
Tony Yates 01:50
Well, the bank gets electronic central bank money or central bank reserves in a financial market equivalent of five-pound notes.
Neil Collins 01:58
When I use the shorthand that essentially it’s printing money, I don’t expect it to be physically printing money. But what you’re saying is that is the effect of that transaction.
Tony Yates 02:09
Yeah, it is. It doesn’t have to be done that way. So you know, there’s a lot of debate and thinking about QE that took place in the decade or more leading up to the US, UK , ECB, Bank of Canada doing QE, prompted by the early 2000s US deflation scare. And, of course, the Japanese themselves being the pioneers in this respect. It was always recognised that one could think of QE in two steps, you could have it done by the debt manager, or depending on how things were set up the central bank; just doing a swap of the long gilts out there in the market for short government securities, or one can do what we did, which is actually to create money in the process,
Jonathan Ford 02:51
We’ll come back to the reserves the money that’s created in a second, but QE has been going on for whatever it is now 13, 14 years – 13 years – it is always anticipated that it will be reversed at some stage through this process called quantitative tightening. Can you just explain for us what exactly that would involve?
Tony Yates 03:12
It involves the opposite of quantitative easing. So, during quantitative easing, we create electronic money, the electronic equivalent of printing, we go out and buy long-term securities. Quantitive tightening is the reverse; we sell those securities and or allow them to mature, the reserves being destroyed in the process. Another way to observe the same thing is that the central bank balance sheet shrinks back towards where it started from. And of course because the big issue is does it shrink back all the way to where it started from – or is there a permanent semi permanent expansion? And what we’re seeing, of course, is that there is in fact, going to be a semi-permanent expansion.
Jonathan Ford 03:47
Why is that expanding today? Why would it not go back to where it started from
Tony Yates 03:51
Because for a variety of reasons, the demand for reserves has gone up, some of it because we’ve changed the way we regulate our counterparties (predominantly the clearing banks), we forced them to hold these things so that they’re in better shape in case of crisis. It’s partly because of the difference in the risk appetite of those institutions, compared to the time before the crisis. So, these institutions we think want to hold their assets in more liquid form than they did before. The worry, the concern for central banks is this looks like permanent monetisation. I mean, indeed, if one had nefariously set out all along to permanently monetise all or part of it, it would look like where we are at. If one simply wanted to try and supply the demand for liquidity that there was then you would have a semi- permanent expansion of the balance sheets. I say semi-permanent because the things that I’ve talked about could always revert.
Neil Collins 04:47
But just before we get onto that, your point about the sort of symmetry between QE and QT – it doesn’t quite work does it? Because when the bank is buying long-dated gilts it’s essentially a price-insensitive buyer, when it’s trying to sell them in the market to try and reverse the QE, then the buyers are savvy, cautious, and often very reluctant buyers. So this process could be extremely expensive in terms of the impact that it has on longer-term rates.
Tony Yates 05:27
You may exaggerate the asymmetry and the difficulties, I think there are difficulties and potentially being gamed, or causing distortions in market prices on either side, a lot of thought and concern and serious worry, went into the quantitive easing stage auction process. But certainly, the whole point of the policy was to allow the economy to recover. And a symptom of that is going to be a recovery in underlying real rates and the appropriate policy rates and expectations of future policy rates. And so whilst debt service cost rises, may seem painful, they were the whole point of it.
Jonathan Ford 06:04
Yeah. And just to Neil’s point, I mean, the Bank of England did anticipate that it could take a loss, unwinding quantitative easing, and therefore did it not obtain at the very beginning, an indemnity effectively from the government say, if you lose lots and lots of money, because you buy gilt for 100, and you can only sell them back for 50, we’ll give you the 50.
Tony Yates 06:26
Indeed, the bank’s own financial position. This is all a material (cosmetically, it’s not immaterial), but yeah, this is one of the great comic aesthetic ironies of the crisis, the authorities created a special purpose vehicle upon which to conduct quantitive easing, you know, the asset purchase facility, you know, which is a separate corporate entity, whose balance sheet, the central bank balance sheet is entirely insulated from legally.
Jonathan Ford 06:51
So the whole thing is on us, the taxpayer. So ultimately, if there are losses in the asset purchase facility, we have to make them up. So the way the circle is closed, is that we get taxed to fill in the losses in the asset purchase facility.
Neil Collins 07:07
Those losses could be very substantial. Because unlike most of the participants in these markets, I am old enough to remember the days of buyers strikes in the gilt market, when the government had to pay 15 and a half per cent for 20-year money. Something like that would be extremely painful today.
Tony Yates 07:26
It could be but again, I think those losses, if one indeed can call them losses will be dwarfed by the fact that the whole point of it was to generate this situation; successful QE, and low-interest rate policy combined, together with all the other policies that were put in place after the financial crisis, ought to be watching the economy into a situation of rebound. Obviously, other things intervened afterwards, and the pandemic. But absent that, this is what one would hope for and the economic returns from doing that would dwarf any effects of this on public finances.
Neil Collins 07:59
It sounds like the operation was a great success, but the patient died.
Tony Yates 08:03
Because it’s not, it’s not concluded, we’ve yet to get these yields back out there.
Jonathan Ford 08:08
The patients still hanging in there! That’s the macro picture of what’s happening here. And indeed, as you interestingly suggest, the sort of losses that the Bank of England’s asset purchase facility might have to take are a) baked into the original structure b) provided for and c) if the economy really got going at great pace and recovered fully it would be fantastic. Is that a fair summary? What do you think, Neil? Is that how you see things?
Neil Collins 08:38
I think that sounds like wishful thinking to me, still.
Jonathan Ford 08:41
I think that’s the structure. But let’s get on to the reality of where we are, which is; we’ve come out of a pandemic, the economy isn’t going very well, but interest rates are going up. And basically, these paper or electronic currency that’s been created to pay for all the gilts that the Bank of England has bought, are themselves receiving a rate of interest on the reserves from the Bank of England, which historically, as I understand it, wasn’t the case – but was introduced after QE. Can you explain why that was?
Tony Yates 09:14
in the run up to QE, there was a lot of debates about what firstly, the economic floor to the policy rate would be – a very simple, economic and finance model and we think of the floor as being zero, an approximation for how much it costs to store and manage paper currency, but let’s just call it zero. On top of that, there was a worry that as you got close to zero, you know, might cause very unpredictable things to happen in financial markets in the US. The particular concern was over what was going to happen to money market funds in the UK because that then wasn’t really a feature. Their main concern was the effect that very low rates would have on some building societies that had exposed themselves to very low nominal rates, and so you might hit their profits and then that would hit rates that they charge to borrowers and the effect of cutting rates beyond some point would no longer be stimulative.
I think the bank used to refer to this as the effective lower bound, the bound below which once you’ve pushed the bank rates, it will no longer be stimulative for the economy. The Bank of England and other institutions, other central banks wanted at the same time to grow central bank balance sheets by doing QE hugely, but they didn’t want the market to experience all the effects of that on market rates, because if you shove a tonne of reserves out into the market, you would expect in a for a given demand, you’d expect the price to fall, the price being the interest rate. So they didn’t want the interest rate to fall. So the idea is just to say we will pay interest on reserves, and that is a way of the interest rate not falling below zero or toward zero or below the effective lower bound, and at the same time being allowed to do QE on a huge scale. So we needed to switch to interest on reserves. It follows from that, therefore, that it was a possible route out of this simply to reverse the set of steps you went into. So first to sell all the gilts back and do quantitative tightening before raising rates, and then either go back to the way we set policy before or to carry on paying interest on reserves right and raise rates afterwards.
Jonathan Ford 11:25
But the issue that’s got people interested in this, is the fact that what is happening in the asset purchase facility is they get the interest on all the gilts they bought from the system. And they then pay reserves to the people who they’ve bought them from. In the last few years, there’s been a very positive net balance. So they’ve collected far more in interest on their gilts than they had to pay out. But now the concern is because the interest they’re paying out on those reserves is going up. But of course, gilts, as Neil knows, being fixed interest just chug on paying the same coupons, there’s a point at which they could cross over, and it could start to become a net cost to the asset purchase facility in that it will need money from somewhere.
Tony Yates 12:14
So this is seen as an opportunity. Raises the question, why should we bother paying interest on reserves?
Neil Collins 12:20
Jonathan Ford 12:21
Why do it? Why not just go say “well we’re back to status quo ante, it’s February 2009, no interest guys get with the programme?”
Tony Yates 12:30
Well I mean, the first thing that we should bear in mind is the tax opportunity, or the public finance opportunity, is not really a public finance opportunity. And I’m not sure what the intent of those people who’ve been writing recently in the commentariat that we should be doing this, but it’s written in a way that makes me feel that they grasp that.
Jonathan Ford 12:48
But there is an opportunity, well, not an opportunity.
Tony Yates 12:52
The way to describe this without trying, I’ll try and do it in a way that doesn’t descend into jargon, although my mind is infested with jargon. So you can do.
Neil Collins 12:59
You can do it!
Jonathan Ford 13:01
Give it your best shot, Tony, don’t hold back!
Tony Yates 13:05
Essentially, when we’re talking about shaking down banks or raiding banks for some more tax. And I’m not against that in principle, but we shouldn’t think of that necessarily as an opportunity. Because we’re all on the other end of banks, almost all of us are. So anything we take from them, we pass on to us. And so if the Treasury were hypothetically to take a stack of money from the banks, then say, “oh, look, we can now repatriate this with some tax cuts”, all it would do is leave people like us exactly where we started.
Neil Collins 13:34
I must say, as a user of a bank, there doesn’t seem to be much correlation between what it costs them to raise the money and what I have to pay for it. And I think that the argument that what is essentially an extra tax on them, would immediately be passed through in higher borrowing costs. I think that’s pretty thin.
Tony Yates 13:57
You can hold that (inaudible) of course, if we do want to tax banks, I think we should just tax them and not try to redesign our entire monetary policy stance mechanism to facilitate one particular tax, when there are many taxes. We tax them all the time, we could just do a windfall tax tomorrow if we wanted, it would have a lot of public support base if, if the voters are like, like yourself,
Jonathan Ford 14:19
Neil, the famous communist.
Tony Yates 14:22
Well, we could prevent them, you know, if they didn’t pass on these benefits or costs, you know, we can force them to do anything. We manage their assets, we manage their liabilities, we manage who directs them. We manage what dividends are paid to their owners. I mean, there’s almost no bit of bank behaviour that we don’t have a finger in – they’re really like nationalised industries!
Jonathan Ford 14:44
We’ve nationalised the banks!
Neil Collins 14:46
Which is why the shares are so low rated, because the shareholders aren’t really in charge.
Jonathan Ford 14:52
But I just want to go back a step for a second and just… you did a fantastic job, by the way, I want to give you an upper second for the jargon-busting, but I just want to summarise what you said just so that it’s absolutely crystal clear, which is essentially; QE has stuffed the banks full of reserves, which are basically the product of selling heaps of gilts to the Bank of England. If you basically conk out their reserves, their return on their reserves, you take away a substantial proportion of their income. And if that happens, effectively, they will find other ways of replacing that income, notably by shafting their customers, you, me and even Neil, the famous communist, who’s indifferent to that, because he doesn’t think it will happen.
Neil Collins 15:45
She’ll pay through the nose anyway.
Jonathan Ford 15:49
Is that a fair characterization, Tony?
Tony Yates 15:51
Yeah I think that’s, I mean, that is to make the point that it’s not really a finance opportunity.
Neil Collins 15:56
So it’s a tax opportunity, if the government chooses to take it.
Tony Yates 16:00
It’s an opportunity to change where the tax falls, it’s not an opportunity to make money. Because like I said, if the government repatriated the proceeds, we’d all be back where we started.
Jonathan Ford 16:10
I think what you’re saying, Tony, is it’s a stealth tax – and you being a straightforward guy want it to be an open windfall tax, if a tax it is to be.
Tony Yates 16:19
More than that; it’s not a tax, that actually leaves us better off.
Neil Collins 16:23
No, taxes don’t generate wealth.
Jonathan Ford 16:24
Very profound point. But I wanted to just touch on another point about QE, one that I suspect nobody really knows the answer to, but you seem to be the most likely person in the room to have an answer. When we talked about money being created, you said, “well, yeah, money was created, but it didn’t really matter, because there was so much money knocking around in 2009, and the economy was so flat on its back, that the idea that that will get anything really to happen in the short term was wishful thinking.” But a huge amount of QE was done after March 2020 in the pandemic, and that money is much harder to say, was not having some sort of stimulative effect, because it was literally being poured out of the government’s coffers, into the pockets of people in all the support programmes that were taking place.
Do you think that there is any kind of difference in your mind between what happened in 2009 and even in 2011, the second wave during the euro crisis? And what’s happened in the last two years? And do you think that it’s got closer to the sort of money printing that’s more the Weimar model than the kind of Mervyn King model, shall we say.
Tony Yates 17:36
When economists would think about it, and I’m imagining your hearts sinking as I am? You know, the furlough and other support policies are a bit like the government handing out food to keep people alive. So that you know, what the government did to differentiate it during the pandemic crisis, I think one can think more economically about it as it being as if we were giving people food.
Neil Collins 18:03
Where do you think we are headed now? Is the money supply now expanding still? Or is it starting to show signs that it might contract? What’s your view on that?
Tony Yates 18:33
I imagine that we probably are heading into recession, then lots of things that one could put under that label will start to shrink, or at least grow much less rapidly than before. And we know what’s happening to central bank reserves, we’re into the territory of what is going to happen to the real economy, which will be the determining factor or the bits of the money supply that, you know, are used to undertake transactions by most people in the (inaudible), I would guess that we are already contracting, and that we will continue contracting for a month or two, at least.
Neil Collins 19:05
When you say we do you mean the economy as a whole?
Tony Yates 19:08
I mean, the economy, you know, if you want to forecast what’s going to happen to the money supply, then you think the best way to do it is to think about it through what’s going to happen to the real economy.
Jonathan Ford 19:17
I think we’ll take that as a yes. Can I just bring it back? Last question from me or two questions, really. First is, what is the incentive for somebody once they’ve created this enormous balance sheet at the Bank of England or the Fed to actually say, “let’s now wind it in, let’s tighten everything up and shrink the balance sheet”? Is there an incentive? Because I struggled to see what it is really, maybe it is this reserves problem or something like that, or just the fact that it begins to get rather expensive to carry on buying all these gilts. And the second question, which is sort of linked to it is; do you think over the next five years we will see a meaningful contraction of the balance sheet of either the Fed or the Bank of England.
Tony Yates 20:04
I mean, all the central bankers that I know and interacted with have always been really uncomfortable by having to do this.
Jonathan Ford 20:10
So they’d like to stop.
Tony Yates 20:12
It forces them into explicit and lots of informal interactions with the finance ministry. You can see that in how Mervyn described the whole thing during his tenure – the insistence that the ATF was created to make sure that the central bank balance sheets were indemnified was an effort to try and keep the central bank and the finance ministries financially disentangled as possible. So I think, although there’s no formal incentive on central bankers to do anything really I mean, you could pose the question, what is the incentive for central bankers to set the right interest rate? Well, the incentives are very weak, you know, they just do their job because they like it, and they care about it. By and large. Plus this sense of discomfort and conservatism, I think that it defies a lot of central bankers. And if I’d stayed in central banking, I think I would have felt the same.
Jonathan Ford 21:03
So you think it’s basically just a cultural thing, they want to go back to what they see as normality, and they regard this as too heterodox for their taste?
Tony Yates 21:11
Yes, I think so. And that, you know, there’s a deep-seated worry that, well, maybe if we don’t get rid of them, people will consider them to be permanently monetised, and therefore, view all the institutions of monetary and fiscal policy as cosmetic and basically disregarded, and then you’re back to actual money financing is back on, and then you’ll lose any hope of achieving price stability. I think that is part of it. Although it’s not often painted in such darkterms.
Neil Collins 21:38
I’d say that’s my view of central banking.
Jonathan Ford 21:40
Yes, a shambles
Nei collins 21:42
Well, no, it’s not a shambles, but they are – the Bank of England Monetary Policy Committee, in my view, has really ignored their mandate, and are struggling to keep up. My concern at this point, is that they will overdo it. And we will have severe contraction as a result of them trying to catch up and get down to the 2% target, which is their mandate. I think that’s what I would say is the most concerning thing at the moment.
Jonathan Ford 22:16
I think you’re setting them up to fail there Neil. It’s a classic Collins nutcracker, you can’t win there.
Tony Yates 22:24
So I think the first part of your comment, though, is far too hash. But I agree with the second part that inflation has got so high that there is going to be a worry about whether they have the right information or even with the right information, they would be able to engineer a relatively soft landing. I’m not that optimistic that they will. We are already heading into recession, although that’s because of monetary policy, but it’ll be aggravated by the tightening.
Jonathan Ford 22:45
And just to come back to my question. Do you think we will get see in the next five years and meaningful shrink?
Tony Yates 22:50
It’s hard to answer that question, isn’t it without trying to forget what happened to you know, China’s COVID policy and the war in Ukraine and all of that.
Jonathan Ford 22:55
It’s the Collins crystal ball!
Neil Collins 22:59
Yeah, unfortunately, it’s made of plastic.
Tony Yates 23:04
Suppose that China abandons its futile zero COVID policy and its contributions to supply chains normalises and let’s suppose that there is some orderly resolution to the war, you know Russia loses, withdraws, and it somehow reverts to stability. Maybe the sanctions regime doesn’t change, because we don’t want to deal with them anymore, given what we know they’re capable of.
Neil Collins 23:29
I think that’s a flying pig I just saw passing the window.
Tony Yates 23:34
We have to condition on something in order to answer the question, what’s going to happen to central banks?
Jonathan Ford 23:38
If all those things are true, it might shrink a bit, is that what you’re saying?
Tony Yates 23:42
Like, I said, we’re gonna bump up against a higher demand for central bank balance sheet size than we had before the financial crisis – how far they would shrink before we got to that higher equilibrium point? I don’t know, you could argue that the Fed discovered it by accident in 2018-ish, the maturity is structured of its purchases was such that just not reinvesting meant a very rapid shrinkage. And arguably that’s why we saw a spike in all kinds of short-term market rates was because they had bumped up against surprisingly high demand for liquidity, and therefore for central bank balance sheet size, so we may find themselves doing the same thing.
Jonathan Ford 24:20
We started out saying ‘All the things you ever wanted to know about quantitive easing but never dare to ask.’ I think I’ve asked them all!
Neil Collins 24:30
That was a long time in finance with Jonathan Ford and Neil Collins. Editing and production is by Nick Hilton, and our sponsorship partner is briefcase dot news. Join us again next week.