“The problem with QE is it works in practice but it doesn’t work in theory,” an often quoted joke said by former Fed chair Ben Bernanke.
But, some are testing that hypothesis.
The backdrop to Thursday’s Bank of England meeting is much more unforgiving than previous ones. A House of Lords committee recently accused the Old Lady of being addicted to QE, while two senior members of the Bank broke ranks and called for a reduction in asset purchases.
Some have said QE is starting to damage the Bank’s reputation. Given that financial markets are largely built on confidence, they would become extremely volatile if investors lost faith in the BoE ability to do its job effectively.
How does it all work
Quantitative easing helps keep borrowing costs low by introducing a buyer – central banks – into corporate and government debt markets that is willing and able to purchase bonds with relatively low yields.
For instance, low or even negative yielding gilts in real terms are purchased by financial institutions who know that central banks are likely to buy this debt off them. The risk of booking poor returns from these assets essentially lies with the central bank, meaning governments and companies can issue debt with low interest rates and still, more often than not, find a buyer.
Asset purchases work in tandem with central banks’ short term interest rate – what they pay out to commercial banks in interest on reserves.
When central banks purchase bonds from banks and financial institutions, they create digital money and accredit banks’ reserve accounts. Now that banks hold a greater share of their assets in cash, instead of debt, they should be incentivised to lend more to boost profits.
The lower the rate the central bank pays out in interest on reserves, the lower the rate commercial banks need to charge on loans to earn a profit. This should put downward pressure on borrowing costs across the economy. Because the supply of money then increases in the economy, banks typically have to reduce rates to attract borrowers.
QE also works by signalling the trajectory of interest rates to financial markets.
However, the main headache for central banks is how to keep borrowing costs affordable as they taper asset purchases. Firms are likely to struggle to find buyers for their debt without offering higher rates. This will be especially true if inflation continues to increase, as investors will dump assets that provide negative real rates of return.
Read more: Eurozone economic growth outstrips forecasts
And, if central banks need to increase rates to put a lid on spiralling inflation, commercial banks will have less incentive to charge lower rates on loans.
However, economists do not expect this happen anytime soon.
“The most important influence on market interest rates is the short term interest rate set by the central bank and expectations of where that’s headed. If those stay low as QE is wound down, any rise in borrowing costs should be small,” thinks Martin Beck, senior economic adviser to the EY Item Club.
Thomas Pugh, UK economist at RSM, agrees, forecasting that “any big jumps in borrowing costs would probably cause the MPC to pause tightening until the market has calmed down.”
Yields on ten-year Canadian government bonds have stayed low despite the Bank of Canada reducing the scale of its bond buying programme twice. Food for thought.
Higher debt costs don’t necessarily mean austerity
QE’s impact on the UK’s public finances has been bought into sharp relief recently after the government’s fiscal watchdog warned that the country’s stock of debt is now much more exposed to interest rate changes.
A shortening of the effective maturity of government debt as a result of QE could “push the debt-to-GDP ratio on to an unsustainable path” if rates rise, the OBR warned in its latest Fiscal Risks report.
In June, the government spent the highest monthly amount on interest payments on record.
Beck warned that “with QE, if the Bank continued to pay the short-term interest rate on reserves, the cost to the public sector would rise much more quickly.”
However, if rates rise as a result of higher than expected economic growth, then the public purse is likely to be in a stronger position due to increased tax receipts and lower unemployment.
Julian Jessop, economics fellow at the Institute of Economic Affairs, said: “The public finances are likely to be in a far better state than if official rates remain at 0.1 per cent because we are back in a deep recession.”
QE also stimulates economic activity by providing cheap money to firms to make investment and hiring financially viable, which generates revenue for the Treasury. Spending on areas such as welfare and healthcare typically falls as economies recover.
“That would mitigate any adverse effect on the public finances were interest rates to rise,” Beck added.
The government could also restructure its stock of debt by issuing longer dated gilts to replace those with shorter maturities, meaning higher servicing costs would be felt over decades rather than years.
Sharpening wealth inequalities
QE has been blamed for widening wealth gaps, particularly since the onset of Covid.
Cheap money tends to inflate prices for houses and stocks, meaning positive wealth effects accrue to asset rich households. This trend has been especially true during the pandemic as governments and central banks have deployed fiscal and monetary support on an unprecedented scale.
However, this may have been offset by QE improving labour market conditions.
Jessop added: “QE can also help the relatively poor in other ways, for example by protecting jobs and making it easier for the government to provide additional financial support to the most vulnerable.”
Boosting employment tends to make “people at the lower end of the income distribution scale better off,” Pugh noted.
But, house prices have increased 30 per cent since their 2008 peak and are expected to increase a further £50,000 over the next five years, while median real terms monthly earnings have barely moved over the same period.
Where do central banks go from here?
The consensus among economists is that QE undoubtedly limited the Covid crisis’ impact on developed economies.
Pugh highlighted that the programme “was very effective early on in the pandemic by using huge amounts of QE to squash any signs of panic in the financial markets.”
“QE has probably had some effect in pushing down long-term market interest rates and signalling that interest rates would be lower for longer,” Beck said.
The tricky part is yet to come. Avoiding market volatility by announcing a reduction in bond purchases and therefore signalling to investors rate hikes are in the pipeline will be difficult.
When should central banks do this? “The Bank of Canada has already started. In my view, the Bank of England should join them next month,” Jessop urged.
Whether it does or does not, QE has obscured the dividing line between what is the right and wrong level of influence central banks should exert on financial markets.