Quantitative Easing: Can it Be Unwound?

Malcolm Sawyer and Philip Arestis

The general response to the financial crisis of 2007 onwards by central banks included large cuts to the policy interest rate and then adoption of ‘quantitative easing’ alongside many other policies of bail-outs. The low interest rate regime aided the government’s budget position by enabling borrowing at low rates. But they did little to aid recovery as economies continued to dip into and out of recession. Central Banks started to engage in ‘quantitative easing’.

‘Quantitative easing’ has been an unorthodox piece of policy comprising of two elements: the ‘conventional unconventional’ measures: whereby central banks purchase financial assets, such as government securities or gilts, that boosts the stock of money in the form of M0; and ‘unconventional unconventional’ measures: in this way central banks buy high-quality, but illiquid corporate bonds and commercial paper. In this way the stock of money is expected to increase.

The Bank of England announced on the 5th of March 2009 a £150bn ‘quantitative easing’, by buying government securities and commercial paper (£50bn on commercial paper); followed by £75bn pounds (equivalent to 5 percent of annual GDP) of the £150bn should be spent on government gilts and commercial paper, over the April-June 2009 period. Subsequently (May 2009) the latter was increased to £125bn (9 percent of annual GDP); increased further to £175bn in August 2009; and to £200bn in November 2009. In February 2010 it was announced that the Monetary Policy Committee (MPC) would monitor the appropriate scale of the QE and that further purchases will be made should the outlook warrant them; this became necessary in October 2011, when QE increased by a further £75bn; and more recently, July 2012, QE increased by a further £50bn. The MPC at its latest meeting on the 4th of July 2013, under a new chairman of the committee, decided to continue with QE.

Those of a more monetarist persuasion saw the corresponding expansion of the stock of money (in the narrow sense of notes, coins and reserves of banks at Central Bank) as inflationary in nature. But there is no evidence that this occurred, and indeed the ‘quantitative easing’ appears to have had little impact on spending. The reserves of the banks have ballooned and there has been little expansion of bank credit for investment and other purposes. Since QE involves the direct purchase of financial assets, it would not be surprising if QE at least held up asset prices. The general rise in stock market prices around the globe fits that pattern, and the falls when it is suspected that QE will be unwound.

In their recent annual report, the Bank of International Settlements warned of the issues which could arise as QE is unwound; and as a number of major countries (notably USA, UK and EMU) practicing QE reversals at the similar times would exacerbate the problems.  The problems could arise from a general fall in asset prices, and specifically the effects which a fall in asset prices would have on the balance sheets of banks and other financial institutions.

Central banks and governments have so far profited from QE as the central bank purchases interest bearing assets for money. As QE unwinds those interest bearing assets will obviously be sold, and a key question becomes at what price. As interest rates would likely be rising and central banks become substantial sellers of financial assets, asset prices are likely to fall. Since QE has involved major purchases of financial assets, a relatively small fall in asset prices (more asset prices at future sale date compared with prices at time of purchase) would generate significant losses. The present purchases under the QE programme amount to some £375 billion. A 10 per cent fall, for example, would involve a significant loss for the Bank of England, and hence for the government as the sole shareholder of the order of £37 billion. The loss can be compared with the current budget deficit estimated for 2012/13 at £110 billion.

In November 2012, an agreement was reached between the Governor of the Bank of England (BoE) and the Chancellor of the Exchequers which has significance for the operation of QE. Under this agreement, the interest the BoE earns on government debt it holds will be returned to the Treasury under the terms of an indemnity provided to the Bank but unused until now in a dedicated account – the Asset Purchase Facility (APF), which is held at the Bank. The APF is a subsidiary of the BoE, which is used to carry out QE through asset purchases, funded by the creation of central bank reserves, with the MPC deciding on the level and pace of asset purchases through the APF as part of monetary policy operations. The APF is financed by a loan from the BoE, and it pays interest on its loan at the going policy rate; all cash accumulated in the APF will be net of these interest payments and other expenses.

The transfers from the APF to the government should be used solely to reduce the government’s borrowing needs and its net debt. The figure rose to £35bn in March 2013 (it was £24bn in March 2012), that is £11bn increase on an annual basis, equivalent to roughly 10% of the budget deficit at £116bn in March 2013 (and 0.7% of national income). This figure comes from the fact that the APF borrows at 0.5% from the BoE and lends the same amount to the Treasury at a higher rate (it is not clear by how much in view of the different maturities of the debt involved).

The excess cash from the APF was transferred to the Treasury during the financial year 2012-2013; in the future, and on a regular basis, any additional interest payments received by the APF will be handed back to the Treasury at the end of each quarter, after deducting relevant costs. The conclusion is, then, that the Treasury, not the BoE, undertakes QE of its own. It would appear that the dividing line between the BoE ‘independent monetary policy’ and the Treasury’s budget plans is becoming rather obscure. Does this mean the beginning of the end of the notion of ‘independent monetary policy’?

The QE programme does not appear to have been a great success in the promotion of economic recovery, though it has held up asset prices. As the QE programme unwinds it is likely to involve the central bank and government in substantial losses, and to have consequences for the stability of the financial system.

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