Why Quantitative Easing is currently so costly

 

Unwinding Quantitative Easing (QE) is currently costing the public a great deal of money. Nearly £50 billion (almost 2% of UK GDP) has been transferred from the Treasury to the Bank of England to cover losses as the Bank unwinds QE (called Quantitative Tightening) since October 2022. That is real money that might otherwise have been spent on improving hospitals, schools etc. (Figures from the latest OBR forecast here, page 120.) It is true that before that QE made the government much bigger profits, but the OBR estimates that once all QE is unwound the net loss will be around £100 billion.

One of the reasons discussion of this has tended to be confined to pages in the Financial Times (see here for example) is that, as with most things finance related, the issue can often get needlessly complicated. In this post I’ll try and make things simpler, and ask whether these losses can be avoided and if not, who is to blame.

First, a reminder of what Quantitative Easing is and why it happened. It involves the Bank of England buying huge quantities of government debt, and paying for this by creating (electronic) money called ‘reserves’ which are held by the major banks. Most of this was done during the recession years after the financial crisis (GFC), but some happened during the pandemic.

Why did the Bank do this? After the GFC the main policy instrument of the Bank, the short term interest rate, was stuck at its lower bound, so instead the Bank was trying to stimulate the economy by putting downward pressure on longer term interest rates. By buying lots of longer term assets like government debt, it hoped it would push up the price of that debt. Most government debt when it is issued has a fixed nominal interest rate, so if the market price of that debt increases, that implies the effective interest rate falls for anyone buying it. [1] As I suggested here, for supply and demand to have any effect on the interest rate for government debt, the Bank needed to buy huge quantities.

As QE was always an emergency measure in a situation where short term interest rates were at their lower bound, it was never intended to be permanent. At some point the Bank would start selling the government debt it held, and using that money to reduce the money/reserves it had created to buy them in the first place. For the Bank the obvious time to start selling is when the economy needed cooling down rather than stimulating, which would also be when short term interest rates were well above their lower bound. That is why we have seen QE being reversed over the last few years.

So why did QE originally make a profit, but is now making a loss? There are two components here. The first is an interest component. The Bank pays the short term interest rate to the major banks on the reserves it created, but it receives the interest rate of the government debt it bought with that money. When short term interest rates were very low, longer term interest rates, including the interest rate on government debt, were higher so the Bank made money by holding this debt. However today the opposite can be true, so the bank could be paying more to the major banks than it’s getting from its holdings of government debt.

The second element involves capital gains and losses. Because the Bank bought government debt when rates were low and debt prices were high, and because it was likely to sell that debt when interest rates were much higher and prices lower, it was likely to sell its debt at a loss. This was understood at the time QE started, so making capital losses is no surprise.

Putting the interest rate and capital gains elements together, we can see why initially QE made the government money, but now it is losing it money. First, any profit or loss the Bank of England makes is picked up by the government. Second, when short term interest rates were low and the Bank was not selling government debt, it made a profit on the interest it received from the government debt. Essentially the government through the Bank was buying back its own debt and saving interest as a result, hardly any of which was going to commercial banks holding reserves because short term interest rates were almost zero.

However, once short term interest rates started rising in 2022, these interest gains started to disappear, because the rate of interest paid to commercial banks on the money created to buy the debt increased by substantially more than the interest the Bank was receiving on government debt. In addition, the Bank was now selling off some of its government debt at much lower prices than it paid for it, so it was making a capital loss. Because the quantities of government debt involved are very large, so is the size of these gains and losses.

Could current losses be avoided? The interest costs could be avoided if the Bank stopped paying the short term interest rate on all the reserves it created. I discussed this possibility here, including suggestions of how this could be done without the Bank losing control over short term rates. Alternatively the government could impose a windfall tax on the banks holding these reserves. How much of either measure would be passed on to bank customers or bank shareholders or bank employees is unclear.

What about the capital losses? I suggested earlier that these were almost baked in from the start, because the Bank would always be buying debt when its price was high and selling when its price was lower. While that is true, whether there is a net loss once interest gains or losses are added in depends on market expectations of future short term interest rates. Although the Bank was buying at a high price, it was receiving a relatively high interest rate in compensation (hence its initial profits). If market expectations about future interest rates when the debt was bought proved correct, then any capital loss would roughly equal the interest gain while the Bank held the debt. [2]

In terms of capital losses, therefore, the worst thing the Bank can do is sell its debt when short term interest rates are unexpectedly high. Interest rates today are indeed unexpectedly high, in the sense that few in 2019 would have expected interest rates at current levels. The problem here is institutional. The Bank has not been charged by the government to minimise its losses from reversing QE, but instead is concerned with meeting its inflation objective.

Who is to blame for these losses? Jo Michell put it nicely when he wrote that the original sin of QE was austerity. We had QE on the scale we did because in 2010 the government reversed Labour’s fiscal expansion. As an expansionary tool QE is undoubtedly inferior to fiscal expansion, which is why austerity was so costly in macroeconomic terms. Fiscal expansion also costs money, but the key difference here is who the money goes to. Most people benefit from higher public spending or a tax cut. In contrast those who gain from the government’s losses from QE are those buying, selling or holding government debt, and currently the commercial banks because they hold reserves.

Austerity from 2010 was enacted by the Coalition government, that rigidly stuck to their spending cuts even when the economy failed to recover. I suspect the politicians at the time ignored any potential future costs from QE because these costs were uncertain and, more importantly, would happen after the next election. As I said at the time, austerity was one of the major macroeconomic policy blunders since WWII, as well as having a devastating impact on public services.

However the Bank of England also oversold the benefits of QE to politicians only too willing to be convinced. Having been given responsibility for managing aggregate demand and inflation, the Bank was reluctant to admit that they couldn’t do this job effectively once short term interest rates hit their floor. This bias within central banks persists even today. As this ECB paper shows, estimates of the impact of QE tend to be much larger if done by researchers in central banks compared to academics.

With QE likely to cost an incoming Labour government large amounts of money that is desperately needed elsewhere, it is time the Treasury cast a more sceptical eye on the advice they receive from the Bank, particularly where that advice may reflect regulatory capture as much as sound monetary policy. Currently it is not clear that monetary policy considerations alone should govern when QE is reversed, and it is also far from clear why commercial banks should keep all the windfall they are receiving from their holdings of reserves. In any future demand led recession, the government should think very hard before agreeing to any request for large scale QE. QE was, and remains, a third best tool for fighting recessions [3], and a first best tool - fiscal stimulus - is easy to implement for any government that controls its own currency.

[1] Suppose the government issues 10 year debt at a fixed 5% interest rate. You buy £1,000 of that, and you get £50 a year for the next 10 years, and then your £1,000 back after 10 years. However, that debt is traded on the market. If after a year interest rates fall to 4%, say, and are expected to stay at 4%, traders will be prepared to buy that debt from you for more than the £1,000 you originally paid, because they will still get £50 a year.

[2] To the extent that the Bank was initially successful at pushing long term interest rates below the price implied by this arbitrage, it will still make a loss.

[3] The Bank should always have the ability to buy large quantities of government debt to resolve market failures (as it did after the Truss fiscal event).