Quantitative Tightening and government spending power

Good morning from New Economy Brief.

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The unwinding of quantitative easing – a ~£900bn bond-buying programme drawn up after the global financial crisis – could leave the next government footing the bill for more than £110bn of losses made by the Bank of England.

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This week’s New Economy Brief provides a simple explainer of quantitative easing (QE) and tightening (QT), and explores the options available to mitigate huge losses for the taxpayer, following the examples of other central banks across the world to protect the spending power of their Treasuries from mass sale of government bonds.

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What is QE?

Quantitative Easing (QE) was introduced in March 2009, in the depths of the financial crisis, with the original intention of trying to support economic activity by reducing the long term cost of borrowing. By purchasing government bonds from banks and other financial institutions using newly created electronic money, the Bank of England would (it was hoped) give those institutions more incentives to then lend money to the rest of the economy. In practice, this impact on borrowing has been limited, but QE in the UK and elsewhere in the world has encouraged banks and other major financial institutions to buy assets like shares and, especially in Britain, property. As a result, economic activity has only been weakly affected, but property prices have continued to rise, worsening inequality.  

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Transfers from the Bank of England to commercial banks. For QE to work, the BoE’s Asset Purchase Facility (APF) acts as a guaranteed buyer of (mostly) government bonds and has acquired almost £900bn of them since March 2009 when the Asset Purchase Facility, established in January that year, came into operation. In return, the BoE increases the reserve accounts of the commercial banks it buys the bonds from, effectively creating new money. The BoE then has to pay interest on those new reserves to the banks. When interest rates are lower than the returns from the bonds, the BoE makes a profit and transfers this to the Treasury. However, since interest rates have risen in recent years, the BoE is now paying out large sums to commercial banks. Its plan to change this situation could cost the Treasury hundreds of billions. In addition, the BoE can lose money by selling bonds back to the market for less than it originally paid for them, as the House of Commons Treasury Select Committee describes.

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Asset price inflation to stimulate demand? Many think QE did a lot of harm, by inflating the price of assets such as shares and house prices, which fuelled inequality as these are mainly held by the well off and increasing their value does very little for the poorest. Simply giving people money might have stimulated the economy more without these problems; the BoE’s own analysis found that for every £1 of QE, only 8p fed into the real economy. However, QE for now appears to be at an end.

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What is QT?

Quantitative Tightening (QT) is the reversal of the QE process. In order to reduce the size of its balance sheet, mindful of the potential need for future interventions and eventual risks to its own credibility as an institution, the Bank of England is making an unprecedented move – selling all the bonds bought through QE. Earlier this year the House of Commons Treasury Select Committee warned that this is a ‘leap in the dark’ as the BoE doesn’t fully understand QT’s effects, despite having “potentially significant impacts for HM Treasury’s spending power for the next decade”.

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What will this cost the taxpayer? The BoE is selling bonds for less than they paid for them, and indemnity laws mean the Treasury has to cover any losses. Economist Daniela Gabor notes that the BoE’s own forecasts show QT could cost the Treasury around £110bn throughout the 2025-2030 parliament under an ‘optimistic’ scenario, whilst “net costs could reach £230bn by 2033, beyond Labour’s wildest green spending dreams”.

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The speed of QT limits the next government’s spending power. For the first time, the BoE and the Debt Management Office (DMO) will be selling government bonds to the market at the same time. The DMO told the House of Commons Public Accounts Committee that in 2023-24, the net supply of gilts (UK government bonds) was “at a historical high” and that bond markets were struggling to absorb them. Increasing the supply of bonds reduces their price and makes future government borrowing more expensive. (Read our previous bond market explainer for more on this.) This means that as QE ‘unwinds’ over the next few years, government borrowing costs will increase just as more spending is needed to fix public services and decarbonise the economy. 

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What could the government do to mitigate the losses?

Last week, the government responded to the House of Commons Treasury Committee, reiterating the importance of central bank independence and their commitment to agreement that the Treasury would cover any APF losses. Given that the BoE’s loss-making gilt sales represent very bad value for the taxpayer, what can be done to mitigate them? Positive Money argues that “it is unclear what is steering the BoE’s decision to time bond sales in a way which would crystallise such significant losses for the public”, or why it is actively selling gilts now – it paid a lot for them with interest rates were low, and will get much less now they are at record highs amid rising demand for government spending. Other countries have protected their taxpayers from losses made from QE, as explained below.

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Keeping the bonds until they mature. Unlike commercial banks, central banks whose assets lose money don’t need to realise that loss immediately. As Positive Money argues, the US and Canadian central banks are being allowed to hold their QE bonds until they reach maturity, and the UK could do something similar rather than having the BoE sell its bonds at a loss and then pass the bill on to the Treasury as currently planned. Experiences in Switzerland and Sweden have confirmed that central banks still function well even when losses on asset purchases put them into negative equity, with liabilities worth more than assets.

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Bring in tiered reserves. Two BoE former deputy governors, as well as former Prime Minister Gordon Brown (the architect of BoE independence) suggested it should pay banks less interest on their reserve deposits to save the Treasury money, but this suggestion has so far been rejected. The European Central Bank, Swiss National Bank and Bank of Japan have introduced tiered reserve systems so banks get the full rate on just part of their reserves, with lower rates or nothing on the rest. The logic being that commercial banks are currently being rewarded without having done anything meaningful to warrant this reward. The New Economics Foundation estimated in 2022 that this could save the government up to £57bn by 2025.

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Tax bank windfalls. Reducing interest on bank reserves works like an implicit tax on the banking sector and its record profits. Since commercial banks are the main beneficiaries of QT, another option would be explicitly taxing bank windfall profits which could recoup some of these gains and offset QT’s fiscal impact – the Thatcher government did this in 1981 and Spain is considering a similar move. 

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‍Slowing the pace of bond sales. Harriet Baldwin MP, Conservative chair of the Treasury Select Committee has argued that a more gradual approach of QT at a slower pace could spread losses out and reduce their impact over a longer period of time. However, last week, Chancellor Jeremy Hunt has said this would only delay losses, not avoid them, and argued that the APF losses should count towards the government’s fiscal rules. Of course, another benefit of faster QT for the Conservatives is that it will constrain the next government's spending power and limits the ability of Labour to achieve their ‘decade of national renewal’- which has arguably been an implicit political objective for some time now.