• Accessibility
• Email alerts
• RSS feeds
• Contact us

Quantitative easing: a dangerous addiction? Contents

---

Chapter 4: The future of quantitative easing

102.We heard concern that central banks have not given adequate thought to the future of quantitative easing. Witnesses told us that the key risks facing central banks were the return of inflationary pressures, the risk that quantitative easing poses to debt sustainability and the lack of clarity on an exit strategy from quantitative easing.

Inflationary pressures

103.There is an active debate about renewed inflationary pressures facing advanced economies around the world, as economies start to recover from the COVID-19 pandemic and expansionary monetary policy is combined with expansionary fiscal policies.115 There is rising concern that bottlenecks in supply chains, the release of pent up demand, and very high levels of personal savings available to spend once COVID-19 health restrictions are removed could result in a higher than expected rise in inflation. CPI inflation in the UK has risen from 0.4% in February 2021 to 2.1% in May 2021, slightly above the Bank of England’s 2% inflation target. Figure 7 shows that the Bank’s official inflation forecasts have underestimated the recent rise in inflation:

Figure 7: Bank of England inflation forecasts and CPI annual inflation rate, 2021 (%)

Source: ’Bank of England under pressure to show it can keep lid on inflation’, Financial Times, (22 June 2021): available at https://www.ft.com/content/9c6487ac-4530-4df6-9dd4-a4b46a180734

104.However, the effect of quantitative easing on inflation, and the extent to which it has increased since the onset of the COVID-19 pandemic, is unclear.

105.Sir Paul Tucker, Research Fellow at Harvard Kennedy School and former Deputy Governor of the Bank of England, told us that quantitative easing “did not work on either side of the Atlantic to get inflation back to target, notwithstanding the scale of quantitative easing.”116 Otmar Issing, President of the Centre for Financial Studies and former Chief Economist of the European Central Bank, also said that the use of quantitative easing had not resulted in central banks being able to meet their inflation targets consistently.117

106.We heard from several witnesses who thought sustained inflation was unlikely. Fran Boait told us that the outlook in the UK appeared to be deflationary, pointing to long-term trends of declining real wages. She said that there is “less evidence to suggest a link between [quantitative easing] and consumer price inflation.”118 Professor Daniela Gabor said that deflation was a bigger risk than a sustained rise in inflation.119

107.Masaaki Shirakawa, former Governor of the Bank of Japan (2008–2013), told us that the risk of sustained inflation was “somewhat overblown.” He said that, even accounting for the rollout of vaccination programmes and increases in demand, it is more likely that economies will return to their pre-pandemic level. He saw no convincing evidence that deflationary structural factors—such as globalisation and technological change—have been reversed.120

108.Lord Turner of Ecchinswell did not think sustained inflation was likely to occur because structural changes in the economy were pushing down long-term prices which made it more likely that advanced economies would experience a period of sustained low inflation. He saw no reason for central banks to tighten policy yet.121

109.Charles Goodhart said there is a long-term reversal of global low-wage manufacturing taking place, which makes it more likely that “the underlying context in which central banks will have to operate over the next few decades will shift from deflationary to inflationary.”122 However, he argued that in the short-term it would be “very unwise” for central banks to change their policy stance because it is still highly uncertain how economies will recover once the pandemic has fully receded.123

110.Dr Mohamed El-Erian thought “there will be a rise in measured inflation” but did not believe it would result in sustained inflation over the medium to long term. 124 Lord Darling of Roulanish said that “it is by no means certain that we are bound to have higher inflation.” Lord Darling said that the focus should still be on providing the necessary support to ensure that the economy will recover. Whilst he agreed that a sharp recovery could lead to some inflationary pressures, “it would be a mistake to think that suddenly we will go back to where we were 20 or 30 years ago, when structural problems caused very high levels of inflation. I do not think we are at that stage, but you have to be mindful of it.”125

111.However, other witnesses expressed concern that the rounds of quantitative easing conducted since March 2020 may prove to be inflationary. Professor Tim Congdon, Founder and Chairman of the Institute of International Monetary Research at University of Buckingham, and Liam Halligan, Senior Economics Commentator at The Telegraph Media Group, both said that rounds of quantitative easing since the start of the COVID-19 pandemic would be inflationary. Professor Tim Congdon said that the expansion of quantitative easing had rapidly increased the quantity of money in circulation. He warned that this could be inflationary if it coincided with excess demand and spending post-pandemic.126 Liam Halligan agreed and said that a concurrent increase in quantitative easing and Government debt could cause inflationary pressures if increased savings that had accumulated throughout the pandemic led to excess demand.127

112.William Allen, Visitor at the National Institute of Economic and Social Research, saw “a clear risk of inflation taking off”. He said that quantitative easing had increased the money supply and that there is a risk that inflation will rise if there is a release of pent up demand, in part driven by the increase in household savings over the COVID-19 pandemic.128

113.David McMillan, Professor of Finance at the University of Stirling, said that, unlike the initial round of quantitative easing in which there was a requirement to recapitalise the banking sector, the current round “is instead directly entering the economy.” He said that an increase in the money supply is not inherently inflationary, but that the potential for higher inflation is realistic if it were to coincide with a strong economic recovery in which demand outstrips supply and real wages increase substantially. However, he said that there are still deflationary factors—such as an ageing population, technological advancements and falling commodity prices—that may mitigate a rise in inflation over the long-term.129

114.Andy Haldane, the outgoing Chief Economist of the Bank of England, has warned against complacency on inflation. In a speech delivered in February 2021, he argued that the UK may experience a “sharper and more sustained rise in inflation than expected.” He warned that it could be difficult to get inflation under control if it was allowed to overshoot and become sustained.130

115.Witnesses agreed that the Bank of England’s response to any sustained inflationary pressures would be a test of its operational independence. Chris Giles, Economics Editor of the Financial Times, said that taking action to keep inflation in check by raising interest rates may put the Bank into conflict with HM Treasury.131 Otmar Issing said action needed to prevent sustained inflation will bring central banks into conflict with their governments. He said:

“It will be a very hard test for the central bank to withstand political pressure and I see a great risk that exit, once needed to nip inflationary development in the bud, might be delayed because central banks have come closer to political decisions during the financial crisis and now in the context of the pandemic.”132

116.The Bank of England’s central projection is that inflation will continue to exceed 2% in the short-term having passed that rate in May 2021, before returning to around 2% in the medium-term.133 The Bank said that the projected near term rise in inflation is due “mainly to developments in energy prices.”134 The Governor reaffirmed this view to us when he said that the Bank expected a short-term rise in inflation, partly due to strong shifts in energy prices and a potential increase in consumer spending, but it did not see evidence that inflationary pressures will persist.135

117.Sir Dave Ramsden, Deputy Governor for Markets and Banking, told us that the Bank of England was assessing the balance between demand and supply, and the extent to which there is excess demand building as the economy recovers. He said that the Bank of England did “not see that being sustained, because we think that momentum will slow in the economy through this year for a number of factors.”136

118.In June 2021, the Monetary Policy Committee said that downside risks to the UK’s economic outlook remained. It highlighted the risks of a resurgence of COVID-19 and said that it expected the boost to GDP provided by increased consumer spending, business investment, and strong Government spending to wane after 2021.137 In June 2021, the Monetary Policy Committee were split by 8–1 in favour of continuing the Bank’s existing programme of Government bond purchases. Andy Haldane, the Bank’s outgoing Chief Economist, voted to reduce the stock of these purchases from £875 billion to £825 billion.138

119.Quantitative easing’s precise effect on inflation is unclear, and the magnitude of recent quantitative easing on future inflation has not yet been established. However, we heard that the latest round of quantitative easing could have an inflationary effect as it coincides with substantial Government spending, bottlenecks in supply, and a recovery in demand after the COVID-19 pandemic.

120.There is a debate about the extent to which renewed inflationary pressures will be sustained over the medium to long term. We heard that the Bank’s response to sustained inflationary pressures will be a test of its independence. While the evidence is mixed, there appear to be short-term price rises across a series of indicators. Central banks in advanced economies appear to see the risks of inflation in terms of a transitory, rather than a more long-lasting, problem. We recommend that the Bank of England clarify what it means by “transitory” inflation, share its analyses, and demonstrates that it has a plan to keep inflation in check if its forecasts prove to be incorrect.

Debt management

Asset Purchase Facility and the indemnity

121.In the UK, the Bank of England created a subsidiary company for conducting quantitative easing called the Bank of England Asset Purchase Facility Fund Limited (usually known as the Asset Purchase Facility). The Bank of England lends money to the Asset Purchase Facility to buy Government or occasionally corporate bonds. The purpose of the Asset Purchase Facility was to permit the Government to provide an indemnity to a ring-fenced entity that would conduct asset purchase operations.

122.When the Bank of England lends money to the Asset Purchase Facility, it increases the size of its balance sheet—the balance of assets and liabilities that it holds. The asset side of its balance sheet is increased in line with the size of its loan to the Asset Purchase Facility, on which it receives interest at Bank Rate. The liability side is increased in line with the increase in reserves, on which it pays interest to commercial banks, also at Bank Rate. Quantitative easing is not intended to lead to a permanent increase in the size of the Bank of England’s balance sheet. When economic circumstances permit, the Bank of England has said that the Asset Purchase Facility will ‘unwind’ its asset purchases. This could, for example, be by allowing bonds to mature or by selling them back to the market.

123.The Asset Purchase Facility receives income from the bonds that it holds through, for example, coupon payments from the Government. This income is used to fund the interest payments on the Asset Purchase Facility’s loan from the Bank of England, along with any administrative costs. It is therefore possible for the Asset Purchase Facility to make a profit, as the money it receives from coupon payments can exceed the interest that it pays at Bank Rate on the loan from the Bank of England. It is also possible that the coupon rate is lower than Bank Rate, particularly if the Bank of England found it was necessary to raise Bank Rate to control inflation, which would lead to a loss.

124.However, the Asset Purchase Facility is fully indemnified by HM Treasury. This means that any loss that might result from purchasing bonds is borne by HM Treasury, and any profits that are gained are owed to HM Treasury. According to the Bank of England, the indemnity is there to guarantee the integrity of the Bank’s balance sheet and to avoid any suspicion that monetary policy decisions “might be taken with a mind to their financial implications for the Bank, rather than purely in pursuit of the monetary policy objectives.”139 When the Bank of England wishes to conduct additional quantitative easing, it is necessary for the Governor to write to the Chancellor to request permission to use the Asset Purchase Facility because of the risk to the public finances.

125.Figure 8 sets out the cash transfer arrangements between the Asset Purchase Facility, the Bank of England and HM Treasury as a result of the indemnity.

Figure 8: Stylised Asset Purchase Facility cash flows

Source: Bank of England, ‘IEO Evaluation of the Bank of England’s approach to quantitative easing’, 13 January 2021: https://www.bankofengland.co.uk/independent-evaluation-office/ieo-report-january-2021/ieo-evaluation-of-the-bank-of-englands-approach-to-quantitative-easing [accessed 6 July 2021]

126.Since it was established, the Asset Purchase Facility has made an operating profit. Between 1 April 2013 and 28 February 2021, the Asset Purchase Facility made payments to HM Treasury which totalled £112.5 billion, with £13.7 billion of this transferred between 1 March 2020 and 28 February 2021.140

The effect on the public finances

127.As described above, if the Bank Rate were to rise above the average rate of return on the assets held in the Asset Purchase Facility, the fund’s interest costs would end up exceeding its receipts. In other words, the cashflow would turn negative and HM Treasury would have to reimburse the Asset Purchase Facility so that it does not make a loss.

128.Figure 9 shows the direct effects of the Asset Purchase Facility on the public finances.

Figure 9: Effects of the Asset Purchase Facility on the public finances

Source: Office for Budget Responsibility, Debt maturity, quantitative easing and interest rate sensitivity (3 March 2021): https://obr.uk/box/debt-maturity-quantitative-easing-and-interest-rate-sensitivity/ [accessed 6 July 2021]

129.In general, quantitative easing has lowered the cost of servicing Government debt by lowering long-term interest rates, which means that the Government can borrow money at low levels of interest. However, while the cost of servicing the Government’s debt has diminished in recent years, this has come at the cost of greater sensitivity to changes in interest rates relative to if there had been no quantitative easing, because lower short-term rates are reflected more quickly in Government borrowing costs as quantitative easing shortens the overall duration of its liabilities.141

130.Dr Ben Broadbent, Deputy Governor for Monetary Policy at the Bank of England, explained that quantitative easing has an impact on the overall cost of Government debt by shortening the maturity of its liabilities. Dr Ben Broadbent told us that a shorter maturity means:

“that (i) the government’s overall debt costs (including any payments to the [Asset Purchase Facility]) are at the margin more sensitive to shorter-term rates, relative to longer-term yields, and (ii) the impact of any lasting change in short and long rates tends to come through more quickly.”142

Figure 10: Mean maturity and redemption distribution of gilts

Source: Office for Budget Responsibility, ‘Debt maturity, quantitative easing and interest rate sensitivity’: https://obr.uk/box/debt-maturity-quantitative-easing-and-interest-rate-sensitivity/ [accessed 6 July 2021]

131.In other words, quantitative easing hastens the resulting increase in the cost of servicing the Government’s debt if interest rates were to rise across the curve. On 6 July 2021, the Office for Budget Responsibility said that since 2008, the proportion of Government debt on which interest rates respond within the first year “has more than doubled”, which “has made the first-year fiscal impact of a one percentage point rise in interest rates six times greater than it was just before the financial crisis, and almost twice what it was before the pandemic, just 18 months ago.”143 In terms of the impact on the overall cost of Government debt, the Office for Budget Responsibility has said:

“To illustrate the potential fiscal impact of an increase in interest rates, 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% of GDP) in 2025–26. To put this into context, it is roughly equivalent to two-thirds of the medium-term fiscal tightening announced by the Chancellor in this Budget.”144

132.However, Dr Ben Broadbent told us quantitative easing “has no bearing on the eventual cost” of any rise in servicing Government debt. He said that while quantitative easing had sped up the increase in the cost of Government debt, this should not be taken in isolation from the fact that the average maturity of the stock of gilts since quantitative easing began has lengthened to 15 years. This means that “the extra cost would come through more slowly than in other jurisdictions.”145

133.Professor Jagjit S Chadha, Director of the National Institute of Economic and Social Research, explained that the cost of servicing Government debt does “not rise immediately in line with Bank Rate” because the average maturity of the stock of gilts is 15 year: “that means any increase in funding costs today only impacts on the small fraction of debt that has to be refinanced (rolled-over) or raised in that year.” He told us that it is “misleading” to suggest that the total stock of Government debt will face an immediate increase in funding costs following a change in the Bank Rate. Instead, the “gradual increase in funding costs affords us time to act on developing sources of tax revenues rather than reducing fiscal support measures too rapidly.”146

134.Professor Jagjit S Chadha stressed that the economic context in which the Bank Rate may rise is key to whether it has a negative impact on the Government’s total stock of debt. He said, “we cannot solely look at changes in funding costs without understanding the cause of those changes. An increase in funding costs related to a rapid return to normal economic activity will not pose anything like the problem that a rapid increase in global interest rates might cause us if our economic cycle did not merit it.”147

135.In other words, the risk to the Government’s finances posed by greater interest rates needs to be contextualised by the likely reason for the increase in the interest rate. On 3 March 2021, the Office for Budget Responsibility set out two reasonable scenarios:

• In a benign scenario where the increase in interest rates reflects higher economic growth, the debt stock could ultimately be lower and the Government’s primary balance more favourable.
• A malign scenario where interest rates rise because investors demand a higher risk premium. This would be more likely to be accompanied by a deteriorating economic and fiscal position. In such circumstances, the Office for Budget Responsibility said the Government may find it difficult to make the spending cuts and tax rises necessary to restore the debt trajectory to a sustainable path.148

136.We note that in a malign scenario there could also be supply chain issues and increasing wage demands which might result in investors seeking an inflation premium on Government debt.

137.In July 2021, the Office for Budget Responsibility modelled the fiscal impact of different inflation scenarios on the Asset Purchase Facility.149

• Under a ‘persistently higher inflation’ scenario, a rising Bank Rate sharply increases payments on reserves, which eventually exceed the coupon income earned, resulting in a deficit in the Asset Purchase Facility.
• Under a ‘temporary inflation shock’ scenario, a sharp increase in Bank Rate would quickly send the Asset Purchase Facility into deficit, but it would return to surplus relatively quickly when the rise in Bank Rate is reversed to reflect the temporary nature of the inflationary shock.
• In the most extreme scenario, a ‘loss of investor confidence’, the Asset Purchase Facility experiences a sharp fall into deficit to begin with. However, in this scenario the surplus in the Asset Purchase Facility rises sharply following the initial fall and keeps rising as the soaring gilt rate would rapidly increase earnings on rolled over gilts.

Figure 11: Net savings to the public sector of the APF based on the Office for Budget Responsibility’s scenarios

Source: Office for Budget Responsibility, Fiscal risks report (July 2021), p 204

138.William Allen, Visitor at the National Institute of Economic and Social Research, said that “in the UK context debt management will be extremely difficult in the coming few years.”150 He told us that “there is a risk that maintaining sustainability in the public finances can become inconsistent or at least difficult to reconcile with achieving the inflation target.”151 Masaaki Shirakawa made a similar point. He told us that, were inflationary pressures to increase and central banks tightened monetary policy significantly, this “could affect financial institutions and government finance.”152

139.We heard several proposals for how the Government and the Bank of England might mitigate the impact that interest rate rises could pose to the cost of servicing the Government’s overall stock of debt.

140.Charles Goodhart proposed that the Bank of England could return to paying zero interest on central bank reserves. He said that it will be politically difficult to maintain the policy of paying interest on reserves were interest rates to rise and the Bank of England were required to make large payments to commercial banks as a result. If there was a period of paying zero interest on reserves, he said that the fiscal cost of interest rate rises would be minimised.153 Philip Aldrick, Economics Editor of The Times, set out the case for Charles Goodhart’s proposal. He said that if interest rates on reserves were removed, the Bank of England would have no requirement to pay interest on its liabilities to the private sector, and the coupon on gilts would instead transfer “back and forth between the Government” and the Bank of England at no fiscal cost.154 Both witnesses agreed that paying no interest on reserves would in effect operate as a tax on the commercial banking sector, whilst Charles Goodhart said that any decision to return to paying zero interest on reserves would have to be taken by the Chancellor.155

141.Sir Paul Tucker told us that in order to make the management of its debt more sustainable, “there must be a chance at some point that the Government will say to the Bank of England, “For God’s sake, can you not stop paying interest on reserves?”” He said that if the Government and the Bank of England were to choose to do so, it would reduce the cost of servicing Government debt and transfer the costs to the banking sector.156

142.Lord Turner of Ecchinswell suggested that, rather than the Bank of England paying zero interest on all reserves, a tranche of reserves could be renumerated at zero interest, while marginal reserves above a certain level could be renumerated at Bank Rate.157

143.Anjalika Bardalai, Chief Economist at TheCityUK, expressed concern about the potential impact of paying zero interest on reserves on the banking sector. She told us that “the policy would be perceived as a form of off-balance sheet accounting” and that it would amount to “a financial penalty” on commercial banks “because they would be prevented from earning interest on the reserves and from increased lending, presumably at a profit.”158

144.William Allen suggested an alternative approach. He proposed that there “should be a compulsory exchange of reserve balances held by the commercial banks for newly issued short and medium-term gilts by the Treasury, so that instead of having a floating interest rate liability the Treasury would have liabilities with interest rates fixed at least for a period ahead”. He said that the benefits of this proposal would be to transfer the interest rate risk from the Government to the commercial banking sector, which would slow down the impact of any increase in short-term interest rates on the public finances, providing the Government with “breathing space in working out what to do in the event that interest rates go up.”159

145.In March 2021, William Allen published a paper which set out how much interest is paid on reserves:

“Simply not paying interest on a large chunk of bank reserves would solve the fiscal problem at a stroke. In effect, it would place all or nearly all of the burden on the shoulders of the banks. Bank reserves are currently around £800 billion, and will be over £900 billion by the time the quantitative easing programme is completed. The interest cost to the banks collectively would be £800 million a year before tax, which they could probably swallow, but of course it could be many times larger if short-term interest rates rose.”160

146.Unlike other witnesses, William Allen thought any decision on central bank reserve policy was within the domain of the Bank of England, rather than HM Treasury. He said that the decision to pay interest on reserves is for the Monetary Policy Committee to decide as it falls within its remit to implement monetary policy. 161

147.Anjalika Bardalai told us that William Allen’s proposal would still represent a loss of interest for commercial banks, but on a lesser scale than the proposals made by Charles Goodhart and Lord Turner.162

148.The Governor did not support any of the proposals that had been put forward to the Committee:

“It would complicate the transmission of monetary policy substantially, because that begins with us setting the short-term official rate—the official Bank Rate. That transmits through the interest rate we pay on the reserves that banks hold at the Bank of England … it would complicate and weaken the implementation of monetary policy.” 163

149.The Governor said that paying zero interest on central bank reserves would not be a decision for the Bank of England. He said, “it is a tax on the banking system. It is not monetary policy; it is fiscal policy.”164

150.We asked the Chancellor what assessment HM Treasury had made of such proposals. He said that HM Treasury is not considering proposals to cease paying interest on central bank reserves. He wrote, “The governance for any future new policies would be based upon the current split of responsibilities between HM Treasury and the MPC. The independent MPC has sole responsibility for the operation of monetary policy, and the Treasury has responsibility for fiscal policy.”165 On 15 June 2021, we wrote to the Chancellor to request he tell us explicitly which institution would be responsible for taking any decision to stop paying interest on reserves.166 The Chancellor replied, “… we have not made an assessment of the specific governance and responsibilities that would apply. Therefore, I hope the [Economic Affairs] Committee will understand why my previous answer instead set out the long-established division of institutional responsibilities that we would apply when considering any new policy in this area.”167

151.The growth of quantitative easing has increased the sensitivity of debt interest spending to changes in short-term interest rates. We are concerned that if inflation rises, the Bank may come under political pressure to not raise interest rates to control inflation because the risk to the public finances and debt sustainability would have increased significantly.

152.Managing the UK’s increased public debt accrued in response to the COVID-19 pandemic will require greater coordination between monetary and fiscal authorities. We heard a range of proposals setting out how the Bank of England and HM Treasury could mitigate the impact that interest rate rises could pose to the sustainability of the Government’s debt. These proposals amount to fiscal policy as they would effectively be a tax on the banking sector—we heard that if Bank Rate was to rise to 1% without interest paid on reserves, commercial banks would forgo around £9 billion a year based on current reserve levels. HM Treasury 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.

Deed of Indemnity

153.Dr Will Bateman, an Associate Professor at Australian National University, said that the Deed of Indemnity for the Asset Purchasing Facility has not been published. He said the Deed of Indemnity provides the legal framework for the indemnification of quantitative easing and that the “secrecy” of the document is an “extraordinary feature of the UK’s quantitative easing programme”. It “is a contractual document between two governmental institutions which commits the UK’s taxpayers to potentially enormous liability and appears to authorise quantitative easing in the UK. It should be published.”168

154.We asked Lord Macpherson of Earl’s Court, who was Permanent Secretary to HM Treasury at the time that the Deed of Indemnity was agreed, why it had not been published. He said, “I seem to remember that, at that time, we were pretty focused on being as transparent as we could be” and “I would hope that, if we forgot in some way to publish it, we could publish it, because it will add to the sum of human knowledge and therefore create a better debate”.169

155.The Governor of the Bank of England told us that the Deed of Indemnity “basically sets out the terms of operations of the Asset Purchase Facility and how the indemnity that the Treasury gives us works. On the question of publication, it is a Treasury document, so it is not something that the Bank of England could agree on its own to publish.” He added, “I could not see anything in it when I read it that I think would excite people if it were published, but it is not my decision—it is the Treasury’s.”170

156.We wrote to the Chancellor to ask whether HM Treasury would publish the Deed of Indemnity. On 10 June 2021, the Chancellor replied but did not say whether the Deed of Indemnity would be published. Instead he wrote, “I would reaffirm the Governor’s remarks during his evidence, that the document does not cause the Bank to have to ask for permissions and it sets out the terms of operations of the Asset Purchase Facility and how the Indemnity works.”171 On 15 June 2021, we asked the Chancellor to clarify his answer and requested that he set out why the Deed of Indemnity had not been published and whether he would now do so.172 On 2 July 2021, the Chancellor replied: “I have carefully considered the case for publishing the Deed of Indemnity and I do not intend to publish the document.”173

157.The asset purchase facility is indemnified by HM Treasury, but the Deed of Indemnity has not been published. This is a contractual document between two public institutions. We heard no convincing explanation for why the document has not been placed in the public domain, which has concealed it from parliamentary and public scrutiny. The Chancellor has repeatedly ignored our requests for an explanation on why the document has not been published. HM Treasury should publish the Deed of Indemnity.

Unwinding quantitative easing

158.Unwinding quantitative easing is a process sometimes referred to as quantitative tightening, which is a contractionary policy applied to decrease the amount of money and liquidity in the economy. This process will involve central banks reducing the size of their balance sheets. They can do this by allowing their bond holdings to mature rather than replacing them, tapering or slowing the amount of asset purchases made, or selling gilts back to the market.174 In 2013, the Federal Reserve announced it would begin to reduce or ‘taper’ the pace of its asset purchases. In reaction to the announcement, which was not expected by the financial markets, bond yields and financial market volatility rose significantly. This response by the financial markets was known as a ‘taper tantrum’ in the financial media.

159.The Monetary Policy Committee has set out the steps the Bank of England will take to reduce the stock of its purchased assets when it judges the time is right to do so:

• First, the Monetary Policy Committee does not intend to begin quantitative tightening until the Bank Rate has risen to a level from which it could be cut if required. The Monetary Policy Committee currently judges that to be 1.5%.175
• Second, quantitative tightening will be conducted over several years at a gradual and predictable pace, taking into account economic and financial market conditions at the time.
• Third, quantitative tightening will take into account the need to maintain order in gilt and corporate bond markets, including through liaison with the Debt Management Office.
• Fourth, the Bank says that quantitative tightening can be amended or reversed as required to achieve the inflation target.176

160.We heard that there are a series of risks facing the Bank of England when it looks to unwind quantitative easing. Dr Mohamed El-Erian identified three risks facing central banks: 1) market instability spilling over into the real economy; 2) a spike in inflation; 3) worsening outcomes of income, wealth and opportunity if the transition does not go smoothly.177 Dr Jim Buller et al, academics from the University of York, identified similar risks: “There is a danger that unwinding quantitative easing will lead to greater price volatility in the bond markets as was experienced in US bond markets in 2013 when the Federal Reserve announced a tapering of its asset purchases.”178

161.Frances Coppola told us that a significant reduction in central bank reserves could threaten the Bank’s financial stability mandate and it is therefore “unlikely that QE will ever be unwound in full.” She said that as a result the Bank of England’s balance sheet will remain considerably larger in future than it was before the financial crisis.179

162.Professor Daniela Gabor told us that the central risk when unwinding quantitative easing is “that it happens too soon and too fast and puts undue pressure on the fiscal stance.” She said that the Monetary Policy Committee should not contemplate unwinding quantitative easing until it has produced substantive research on the fiscal–monetary interlinkages of quantitative easing.180 Donald Kohn, former Vice Chairman of the Board of Governors of the Federal Reserve System, told us that central banks should not begin to unwind quantitative easing until it is “no longer needed to achieve its goals for economic and price stability.” He said that central banks would need to judge whether the economy was approaching full employment, whether inflation was stable and whether financial markets were functional. If central banks “saw inflation expectations rising above what you thought was consistent with your objective, that would be a very strong signal that it was time to back off very quickly, maybe even to raise rates.”181

163.Christina Parajon Skinner, Assistant Professor of Legal Studies and Business Ethics at the Wharton School of the University of Pennsylvania, told us that the Bank of England should not attempt to normalise policy until it is sure that the banking sector is resilient enough, and that it would not cause market dysfunction.182

164.However, Aberdeen Standard Investments, an asset management company, said there is no reason to think that unwinding quantitative easing will trigger panic or result in dysfunctional financial markets. It said that the sale of gilts back to the market would “probably exert only very little upward pressure on long run interest rates.” It could not foresee any issues for the Bank of England in setting interest rates “and exerting control and influence over various short-term funding rates with a permanently larger balance sheet.”183

165.We received evidence that said the Bank of England was unlikely to unwind quantitative easing in full. Dr Mohamed El-Erian told us that central banks were increasingly facing a “no-exit paradigm” from quantitative easing.184 The former Governor of the Bank of Japan, Masaaki Shirakawa, set out a risk that advanced economies such as the UK are on the same economic trajectory as Japan, which has experienced sustained deflation since the early 2000s. Masaaki Shirakawa told us that there are broadly four similarities between Japan’s experience and the current macroeconomic environment in advanced economies:

• the development of a financial bubble, followed by a financial crisis;
• protracted low growth and low inflation following the most acute phase of the financial crisis;
• the similarity of the monetary policy response after the outbreak of financial crisis. For instance, low interest rates, the use of quantitative easing, huge expansion of the central bank balance sheet, the purchase of corporate bonds and the use of forward guidance;
• an overreliance on easing monetary policy to stimulate inflation and growth and slow progress in implementing reforms to address structural issues.185

166.Blonde Money, an independent macroeconomic research consultancy, told us:

“All of the evidence from the major central banks that have engaged in QE is that it is almost never unwound. Balance sheets remain permanently higher. Central banks find it hard to find the moment at which it can be done without destabilising either the economy or the market, and if they wait too long, another crisis emerges to which the answer becomes even more QE.”186

167.The TUC said that the “evidence of the past decade is of increased not reduced reliance on quantitative easing.” Any unwinding of quantitative easing appeared to be a “distant prospect.”187 Chris Giles made a similar point. He said that it is likely quantitative easing will persist “for as long as interest rates are effectively on the floor.” He said that the Bank would not be able to unwind quantitative easing until aggregate demand was strong enough for it to be able to raise interest rates.188

168.We heard that there was a risk that central banks would come under political pressure when they look to unwind quantitative easing. Otmar Issing said that central banks’ increasing tendency to expand asset purchases will make unwinding quantitative easing more difficult for two reasons. First, the expansion of quantitative easing increases the amount of public debt that is exposed to the risk of rising interest rates, making it more difficult for central banks to unwind their asset purchases without creating issues for public finances. Second, central banks will come under political pressure to maintain their asset purchase programmes. He said that it will be a “tremendous challenge” for central banks to shrink their balance sheets in the face of political pressure.189

169.Dr Jim Buller et al said that the Bank of England may come under political pressure to avoid unwinding quantitative easing if unwinding clashes with the Government’s other macroeconomic policy objectives. Dr Jim Buller et al said that there are legitimate reasons to expect the Government to pressure the Bank of England due to the “policy interdependence of quantitative easing and government fiscal policy.” Were that to occur, markets were likely to respond with “increased volatility to any announced unwinding of quantitative easing due to increased uncertainty”, which would further reduce the likelihood of quantitative easing being unwound.190

170.Witnesses told us that it is important that the Bank of England sets out a clear policy path that it will follow when it decides to unwind quantitative easing. Stephen G Cecchetti, Rosen Family Chair in International Finance at Brandeis International Business School, said that central banks need to set out with clarity and transparency a short-term policy that plans for restoring policy to sustainable settings.191 Donald Kohn said that it is important central banks set out a framework that they will follow as they look to exit unconventional policies. He said that setting out a framework in advance would give markets “good warning” that the central bank was approaching the point at which it would consider unwinding its asset purchases. This would mean that any market volatility can be built into the model, meaning that it would cause less volatility than a sudden exit.192

171.Otmar Issing cautioned that unwinding quantitative easing is effectively a judgement call for central banks and “it is not as simple as having a kind of blueprint for future action because it depends on many variables.”193

172.The Governor of the Bank of England told us that “there are no natural limits” to quantitative easing. He said that it is unlikely that central bank balance sheets will return to a similar level to before the financial crisis partly because “demand for liquidity in central bank reserves has risen, in good part because of the experience of the shortfall in liquidity … [during] the financial crisis.”194

173.The Bank of England told us that the asset purchases undertaken since March 2020 have reduced the ‘headroom’ available within the Bank’s self-imposed constraints, but “if needed, the Bank could re-evaluate some of its self-imposed constraints, to create more headroom should the MPC decide further quantitative easing is necessary.”195 We note that recent Monetary Policy Committee minutes have been dominated with discussion on options for loosening monetary policy rather than on options for tightening monetary policy.

174.The Bank said that in the event that panic is triggered in financial markets, “it is quite possible that there may be circumstances where the MPC would not act to quell market disorder if doing so ran counter to monetary stability.” It said that an important area of future research and policy consideration is the development of new tools, besides quantitative easing, that could help deal with market dysfunction.196 The Governor said that the Bank of England has been assessing its monetary policy options over the last year and pointed to its evaluation of negative interest rates. The Bank of England views its monetary policy options as “broad and not narrow”; “it is useful to have other possible tools.”197

175.When we asked the Governor whether the Bank of England would publish a roadmap for its exit from quantitative easing, he would not commit to doing so. He said that the Bank would publish a roadmap “at a point when we think that is the appropriate thing to do, subject to the review [of its exit strategy] we are doing.”198

176.The Governor told us that the Bank of England is reviewing whether to reverse the order in which it committed in 2018 to tighten policy.199 The Bank’s policy since 2018 has been to begin to unwind asset purchases only when interest rates had reached 1.5%. However, the Governor has recently expressed his preference to reduce the Bank’s balance sheet prior to hiking interest rates in order to give the Bank more room for manoeuvre in future downturns.200 He told us that, given the economic and health shocks since 2018, there is a “really strong case to re-evaluate that decision [to unwind asset purchases once interest rates hit 1.5%] in the light of what has happened since”. Any decision the Bank comes to will be done on “a predictable basis, which is announced in advance.”201

177.There is an increasing risk that central banks are facing a “no-exit paradigm” from quantitative easing. No central bank has managed successfully to reverse its asset purchases over the medium to long-term, and the key issue facing central banks as they look to halt or reverse quantitative easing is whether it will trigger panic in financial markets that spills over into the real economy.

178.It is not clear whether the Bank of England intends to raise interest rates or unwind quantitative easing first when policy is tightened. The Governor told us that the Bank of England is reviewing the order in which it intends to tighten policy but would not commit to publishing a roadmap. 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 for tightening policy. This is concerning considering the renewed debate about inflationary pressures.

179.The Bank of England needs to set out a short-term plan for restoring policy to sustainable levels. We recommend that it expedites its review as a matter of urgency. As part of the review, the Bank should outline a roadmap which demonstrates how it intends to unwind quantitative easing in different economic scenarios.

---

• A-Z index
• Glossary
• Contact us
• Freedom of Information
• Jobs
• Using this website
• Copyright