Summary
Quantitative easing
In 2009, with the economy suffering from a severe fall in aggregate demand following the global financial crisis, the Bank of England introduced a new monetary policy tool called ‘quantitative easing’. The policy involves the Bank of England creating new money to purchase Government bonds on the open market. Its aim is to inject liquidity into the economy, which the Bank believes will have beneficial effects. These include lowering interest rates, increasing lending, and boosting investment.
Since March 2020, the Bank of England has doubled the size of the quantitative easing programme. Between March and November 2020, the Bank of England announced it would buy £450 billion of Government bonds and £10 billion in non-financial investment-grade corporate bonds. In total, by the end of 2021, the Bank will own £875 billion of Government bonds and £20 billion in corporate bonds. This is equivalent to around 40% of UK GDP.
Therefore, the scale and persistence of the quantitative easing programme are substantially larger than the Bank envisaged in 2009. Once considered unconventional, more than a decade after its introduction, quantitative easing is now the Bank of England’s main tool for responding to a range of economic problems. These problems are quite different from those of 2009.
We recognise that both the global financial crisis and the economic crisis following the COVID-19 pandemic have involved shocks and great uncertainty of the kind outside standard models and, inevitably, the Bank had to both feel its way and take quick decisions that involved a great deal of judgement.
Inflation
Despite a growing economy and expansionary monetary and fiscal policy, central banks in advanced economies appear to see the risks of inflation in terms of a transitory, rather than a more long-lasting, problem. At the time that this report was published, the Bank of England’s policy was to follow through with its decision to continue purchasing bonds until the end of 2021, contrary to the view of its outgoing chief economist.
Quantitative easing’s precise effect on inflation is unclear. However, we heard the latest round of quantitative easing could be inflationary as it coincides with a growing economy, substantial Government spending, bottlenecks in supply, very high levels of personal savings available to spend, and a recovery in demand after the COVID-19 pandemic. The official inflation rate is already higher than the Bank of England’s previous forecasts. The Bank of England forecasts that any rise in inflation will be “transitory”; others disagree.
We call upon the Bank of England to set out in more detail why it believes higher inflation will be a short-term phenomenon, and why continuing with asset purchases is the right course of action. If the Bank does not respond to the inflation threat sufficiently early, it may be substantially more difficult to curb later. The Bank should clarify what it means by “transitory” inflation, share its analyses, and demonstrate that it has a plan to keep inflation in check.
Risk to the public finances
If inflation is sustained and economic growth stalls, there is a risk that the cost of servicing Government debt would increase significantly. On 3 March 2021, the Office for Budget Responsibility said that “if short- and long-term interest rates were both 1 percentage point higher than the rates used in our forecast–a level that would still be very low by historical standards–it would increase debt interest spending by £20.8 billion (0.8 per cent of GDP) in 2025–26.” Quantitative easing hastens the increase in the cost of Government debt because interest on Government bonds purchased under quantitative easing is paid at Bank Rate, which could be much higher than it is now (0.1%) if the Bank of England had to increase Bank Rate to control inflation. As a result, we are concerned that if inflation continues to rise, the Bank may come under political pressure not to take the necessary action to maintain price stability.
We heard proposals setting out how the Bank of England and HM Treasury could reduce the effect of potential interest rate rises on the public debt. These included an option to not pay interest on commercial bank reserves. We recommend that HM Treasury review such proposals and set out clearly who would be responsible for implementing them, as they would effectively be a tax on the banking system. HM Treasury’s response to us on this question was ambiguous. It needs to clarify and put beyond doubt whether any decision to cease paying interest on reserves would be taken by Ministers, not the Bank of England.
The contractual document (the ‘Deed of Indemnity’) between HM Treasury and the Bank of England which commits the taxpayer to paying any financial losses suffered by the Bank of England that might result from the quantitative easing programme has not been published and is hidden from public scrutiny. The document was described as uncontroversial by the Governor of the Bank of England and by the former Permanent Secretary to HM Treasury who was in post at the time that the document was drawn up. Nevertheless, the Chancellor refused to make the document public without explaining why. We believe this is extraordinary and we call for its publication.
Allegations of deficit financing
While the UK can be proud of the economic credibility of the Bank of England, this credibility rests on the strength of the Bank’s reputation for operational independence from political decision-making in the pursuit of price stability. This reputation is fragile, and it will be difficult to regain if lost.
While the Bank has retained the confidence of the financial markets, it became apparent during our inquiry that there is a widespread perception, including among large institutional investors in Government debt, that financing the Government’s deficit spending was a significant reason for quantitative easing during the COVID-19 pandemic.
These perceptions were entrenched because the Bank of England’s bond purchases aligned closely with the speed of issuance by HM Treasury. Furthermore, statements made by the Governor in May and June 2020 on how quantitative easing helped the Government to borrow lacked clarity and were likely to have added to the perception that recent rounds of asset purchases were at least partially motivated to finance the Government’s fiscal policy. We recognise that it is not easy to distinguish actions aiming to stabilise bond prices and the economy from actions oriented to funding the deficit. Nevertheless, if negative perceptions continue to spread, the Bank of England’s ability to control inflation and maintain financial stability could be undermined significantly.
The level of detail published by the Bank on how quantitative easing affects the economy is not sufficient to enable Parliament and the public to hold it to account. This has bred distrust. The Bank of England should be more open about its “assessment processes” for calculating the amount of asset purchases needed to achieve a stated objective. In its public communications, including Monetary Policy Committee minutes, the Bank should publish its assumptions, along with its assessment processes, analyse the breakdown of the effect of quantitative easing at each stage of the programme and examine the extent to which it has achieved the Bank’s stated targets.
Impact of quantitative easing
We took evidence from a wide range of prominent monetary policy experts and practitioners from around the world. We concluded that the use of quantitative easing in 2009, in conjunction with expansionary fiscal policy, prevented a recurrence of the Great Depression and in so doing mitigated the growth of inequalities that are exacerbated in economic downturns. It has also been particularly effective at stabilising financial markets during periods of economic turmoil.
However, quantitative easing is an imperfect policy tool. We found that the available evidence shows that quantitative easing has had a limited impact on growth and aggregate demand over the last decade. There is limited evidence that quantitative easing had increased bank lending, investment, or that it had increased consumer spending by asset holders.
Furthermore, the policy has also had the effect of inflating asset prices artificially, and this has benefited those who own them disproportionately, exacerbating wealth inequalities. The Bank of England has not engaged sufficiently with debate on trade-offs created by the sustained use of quantitative easing. It should publish an accessible overview of the distributional effects of the policy, which includes a clear outline of the range of views as well as the Bank’s view.
More effective countervailing policies can be introduced by Government if these negative distributional effects are better understood. We therefore recommend that HM Treasury respond to research produced by the Bank on the distributional effects of quantitative easing.
While the scale of quantitative easing has increased substantially over the last decade, there has not been a corresponding increase in the Bank of England’s understanding of the policy’s effects on the economy in the short, medium and long term. We also note that the central bank research which does exist, tends to show quantitative easing in a more positive light than the academic literature. We recommend that the Bank of England prioritises research on:
- the effectiveness of quantitative easing’s transmission mechanisms into the real economy;
- the effect of quantitative easing on inflation and how it helps the Bank to meet its inflation target; and
- the impact that quantitative easing has had on economic growth and employment.
Unwinding quantitative easing
No central bank has managed successfully to reverse quantitative easing over the medium to long term. In practice, central banks have engaged in quantitative easing in response to adverse events but have not reversed the policy subsequently. This has had a ratchet effect and it has only served to exacerbate the challenges involved in unwinding the policy. The key issue facing central banks as they look to halt or reverse quantitative easing is whether it will trigger panic in financial markets, with effects that might spill over into the real economy.
The Bank of England is unclear on whether it intends to raise interest rates or unwind quantitative easing first when it decides to tighten monetary policy. In 2018, the Bank suggested that tightening would first come in the form of higher Bank Rate; more recently, the Governor has suggested unwinding quantitative easing might be the first move in any tightening. The rationale for reversing the order in which policy is tightened is yet to be fully explained, and we are concerned that the Bank does not appear to have a clear plan. This is concerning considering the renewed debate about inflationary pressures.
The Governor told us that the Bank of England is reviewing the order in which it would tighten policy. It should expedite the review and we recommend that it sets out a plan for restoring policy to sustainable levels. The Bank should outline a roadmap which demonstrates how it intends to unwind quantitative easing in different economic scenarios.
Update to the Bank’s mandate
During our inquiry, the Chancellor updated the Bank of England’s mandate to confirm that the Monetary Policy Committee is required to support the Government’s economic policy to achieve balanced, sustainable growth consistent with a transition to net zero carbon emissions. The Monetary Policy Committee is required to support the Government’s economic policy as a secondary objective. Its primary objective is to control inflation.
We conclude that any changes to the Bank’s mandate must be considered carefully. Environmental sustainability and the transition to net zero are important issues, but HM Treasury’s instruction is ambiguous, and its interpretation has been left to the discretion of the Bank. We believe that without some clarification from the Government, the Bank risks being forced into the political arena, exposing it to criticism unnecessarily. The Chancellor should write to the Governor to clarify the Government’s expectations.