The Bank of England today cut Bank Rate by 50 basis points to 0.50% and announced the start of its quantitative easing (QE) operations. Although no major damage was done through these decisions, both measures are disappointing and put the Bank further behind the curve.
What’s wrong with a zero Bank Rate?
Why 50 basis points off Bank Rate rather than the MPC swallowing deeply and setting Bank Rate at zero immediately? The answer given in the statement released today by the MPC was that “… the Committee also noted that a very low level of Bank Rate could have counter-productive effects on the operation of some financial markets and on the lending capacity of the banking system. ” That statement is kvatsch. If banks (or other financial institutions) have locked themselves into contracts that cause losses when Bank Rate gets very close to zero, say because the rates paid by banks to their creditors are constrained not to be negative, then a zero Bank Rate would be unpleasant for these banks. They will just have to grin and bear the losses as regards their existing contracts and make sure not to include the offending clauses in any new contracts. It is as easy technically to pay negative deposit rates as positive deposit rates. Depositors threatening to hold their wealth in the form of coin and currency should be told to do so. The inconvenience and risk of holding and storing physical coin and bank notes would soon become apparent.
The Bank’s own money market operations might have to be changed when Bank Rate hits zero, although this is not obvious, as long as the Bank is willing to pay negative interest on deposits held with it by commercial banks and building societies in excess of the average agreed at the beginning of the reserve maintenance period. For those who like this kind of thing, here is the Bank’s own short summary of objectives and methods for its money market operations:
The two objectives are:
“(i) To implement monetary policy by maintaining overnight market interest rates in line with Bank Rate, so that there is a flat risk-free money market yield curve to the next MPC decision date, and there is very little day-to-day or intraday volatility in market interest rates at maturities out to that horizon.
(ii) To reduce the cost of of disruption to the liquidity and payment services supplied by commercial banks. The Bank does this by balancing the provision of liquidity insurance against the costs of creating incentives for banks to take greater risks, and subject to the need to avoid taking risk onto its balance sheet.”
The methods are described as follows:
“The framework has four main elements:
- Reserves-averaging scheme. Eligible UK banks and building societies undertake to hold target balances (reserves) at the Bank on average over maintenance periods running from one MPC decision date until the next. If an average balance is within a range around the target, the balance is remunerated at Bank Rate.
- Operational Standing Facilities. Operational standing deposit and (collateralised) lending facilities are available to eligible UK banks and building societies. They may be used on demand. In normal circumstances, the lending / deposit rates are 25bp higher than Bank Rate and 25bp below Bank Rate respectively.
- A Discount Window Facility. This is a facility to provide liquidity insurance to the banking system. Eligible banks and building societies may borrow gilts, for up to 30 days, against a wide range of collateral in return for a fee, which will vary with the collateral used and the total size of borrowings.
- OMOs. Open market operations (OMOs) are used to provide to the banking system the amount of central bank money needed to enable reserve-scheme members, in aggregate, to achieve their reserves targets. OMOs comprise short-term repos at Bank Rate, long-term repos at market rates determined in variable-rate tenders and outright purchases of high-quality bonds. “
So the Bank could implement its existing procedures with a zero Bank Rate and a minus 25 basis points operational standing deposit facility rate. Instead of persisting in its current inefficient and ineffective methods of overnight (collateralised) lending and deposit taking – an expression of the wish to control both price and quantity of overnight reserves – it would be much simpler (and more likely to satisfy objective (i) above) to abolish the reserve averaging scheme and to narrow the spread between the rates on the two Operational Standing Facilities (the operational standing collateralised lending facility and the operational standing deposit facility) to zero from its current value of 50 basis points. The Bank would be ready, during a reserve maintenance period, to lend overnight (collateralised) any amount, 24/7, at Bank Rate and to accept any amount of overnight deposits, 24/7, at Bank Rate.
The Bank has moved half-way towards this sensible procedure by eliminating the 25 basis points penalty for holding deposits. That makes it even harder to understand why, given the atrocious condition of the British economy and the near-certainty that the inflation target will be undershot in the second half of the year (barring a collapse of sterling), Bank Rate was not cut to zero today. It may not help much, but it won’t hurt.
Are gilt rates too high?
The Bank also announced that it would engage in up to £75 bn worth of financial asset purchases in the first instance (the Chancellor hinted at an eventual total of £150 bn), financed with higher bank reserves at the Bank of England. Such reserves count as part of the monetary base, M0. The assets to be purchased include both high-grade corporate securities and medium-to long-term gilts (maturities between 5 and 25 years).
Under the Asset Purchase Facility announced earlier (which is included in totay’s totals), the counterpart on the Bank of England’s purchases of up to £50 bn of private securities are Treasury deposits with the Bank of England. These don’t count as part of base money. The Bank would buy the private securities, increasing commercial bank reserves with the central bank. The Treasury would sell Treasury bills, mopping up (sterlising) the increase in bank reserves and deposit the receipts from the Treasury Bill sale with the central bank. With sterlisation, the private sector ends up holding Treasury Bills rather than deposits with the central bank. Not much of a difference, really, as Treasury bills are highly liquid and can be repoed at the central bank.
But why does the Bank of England wish to purchase mainly medium-term and long-term Treasury bonds (gilts)? There are no asset market anomalies in the gilt market that make such purchases desirable. The gilts markets have remained liquid throughout. Medium- and long-term rates are not abnormally high. If anything they are uncomfortably low for such institutional investors as pension funds and insurance companies. Temporary monetisation of government gilt sales may become sensible in months to come, as the government deficit explodes, but it is not a priority at all at this moment. 5-year gits today yield 2.26 percent, 10-year gilts 3.30 percent, 20-year gilts 4.31 percent and 30-year gilts 4.20 percent. Assuming the Bank of England will achieve the inflation target of 2.0 percent on average over the next 10-, 20- and 30-year horizon, these rates don’t look at all high. If anything, I would like to see them rather higher.
The anomalies are to be found in the cost and availability of private funds. Corporate bond spreads over sovereigns are unusually wide. Interbank spreads over the OIS rate are low compared to the cardiac arrest period that followed the demise of Lehman, the (first) rescue of AIG and the initial rejection of the TARP, but high by any other metric. Other credit risk spreads and liquidity spreads continue to suggest disfunctional private markets. The effective way to address these anomalies is to intervene in these disfunctional markets directly, by purchasing private securities and by engaging in unsecured lending (in the interbank market and elsewhere). Instead the Bank decides to focus on buying masses of public sector instruments for which yields are, if anything, too low.
A defense of the Bank’s approach to QE could be that what matters is not the asset side of the Bank’s balance sheet but the liability side. The Bank wants to increase the stock of base money. Private assets are in limited supply, so the quickest way to increase the stock of base money is to purchase gilts. But why would an increase in the stock of base money help the provision of credit to the private sector by banks? Will banks, unless the spread anomalies are reduced and the fear and loathing that pervade the financial markets vanish, actually be induced to engage in more risky lending to households and non-financial enterprises simply because they hold more reserves with the central bank? I doubt that additional bank reserves will be burning holes in the pockets of the bankers.
It is certainly not helpful from the point of view of getting the banks to use the additional reserves they hold to boost their lending, that the Bank of England has reduced the opportunity cost to commercial banks of holding large reserves, by eliminating the 25 basis points penalty on the operational standing deposit facility. A while ago, the ECB, faced with the problem that commercial banks took the liquidity it injected into the market and redeposited it with the Eurosystem rather than lending it out or using it to purchase private secutiries, raised the penalty on ‘excess deposits’ from 25 basis points to 100 basis points (the total ‘corridor’ between the ECB’s overnight lending rate and its overnight borrowing rate is now 200 basis points, as opposed to 25 basis points for the Bank of England) . But the Bank of England today moved in the opposite direction. Strange indeed.
So two yawns for the Bank of England today. Could do better.