Quantitative easing (QE – the purchase of government securities by the central bank, financed through increases in base money) in the UK is not working. I should have written “not yet”, for posterior coverage reasons, but I’m running out of patience with a policy that (a) has been ineffective for the half year of its existence and (b) can be easily modified to make it more effective. Credit easing (CE – the outright purchase of private securities by the central bank) in the UK really hasn’t been tried. Of the total Asset Purchase Facility limit of £175 bn, up to £50 bn could have been used to purchase private securities outright. Instead, out of the just under £154 billion purchased up to 24 September 2009 (see here), only £2 bn of private securities have been purchased by the Bank of England. The rest of the £175 bn Facility has been or will be devoted to purchases of UK Treasury securities. No doubt this gives the Chancellor of the Exchequer a warm feeling inside, but from every other perspective it looks like a poor use of Bank of England resources.
Since QE started in January 2009, the Bank of England’s balance sheet has continued to explode, as is clear from the Table below, which shows the Bank of England’s Balance Sheet at the end of July 2007 (just before the crisis) and at the end of August 2009. The total size of the balance sheet rose from £80.3 bn to £220.3 bn. The peak of the Bank of England’s balance sheet size so far was at the end of July 2009, when it stood at £245.3 bn, more than three times its July 2009 size. This is the largest proportional increase in the size of the balance sheet of any of the leading central banks.
|Table 1Consolidated Balance sheet of the
Bank of Englandend of period, NSA, £bn
|July 2007||August 2009||July 2007||August 2009|
|Short term OMOs||32.0||0.0||Notes in circulation||40.1||46.7|
|Long term reverse repo||15.0||52.7||Reserve Balance liabilities||17.2||136.4|
|Advances to central government||13.4||0.4||Standing Facility deposits||0.0||0.0|
|Other securities acquired via market
|7.6||13.3||Short term OMOs||0.0||0.0|
|Total other assets||12.4||153.9||Foreign currency securities||4.3||3.8|
|Cash ratio deposits||2.7||2.5|
|Total assets||80.3||220.3||Total liabilities||80.3||220.3|
|Source: Bank of EnglandTotal may not equal sum of column items because of rounding errors|
UK banks take all the liquidity the Bank of England is injecting through its massive purchases of British government securities (gilts) and promptly turn around and re-deposit that liquidity with the central bank as commercial bank reserves held with the central bank or, in Bank of England lingo, as Reserve Balance Liabilities, which went up by £119.2 billion between July 2007 and August 2009 (see the Table). Notes in circulation increased very little (by £6.6 bn); it was the electronic component of base money that did the job on the liability side of the balance sheet.
There was no material change in Bank of England collateralised lending to the UK banking sector over that period: short term OMOs (open market operations) declined by £32 billion and Long Term Reverse Repo increased by £37.7 bn. The big increase on the asset side is the £141.5 bn increase in Total Other Assets (overwhelmingly outright purchases of gilts), which lines up rather well with the increase in bank reserves held with the Bank of England of £119.2 bn.
The first bit of evidence that UK-style QE isn’t working comes from the behaviour of the broad monetary aggregates and from UK bank lending.
M0 is defined as the sum of notes and coin in circulation plus Banks’ & Building Societies’ Reserve Balances (NSA, £ bn, monthly average); the broad money concept in the charts that follow is UK M4 Holdings by Private Nonfinancial Corporations & Households (SA, £ bn, end of period) and the bank lending measure is UK MFI Lending to Private Nonfinancial Corporations & Households (SA, £ bn, end-of-period). All data are from the Bank of England’s website-accessible data base.
Charts 1, 2, 3 and 4 demonstrate how the injection of narrow money into the economy – specially rapid since March 2009, has failed to provide a significant boost to broad money (M4 held by the non-financial sector) or to bank lending (MFI lending to private non-financial corporations and households. Chart 1 shows the levels of the three series, Chart 2 their change from the initial date (May 2006) and Chart 3 their first differences. Chart 4 shows the money and bank lending multipliers, the ratio of M4 to M0 and the ratio of M4 lending to M0. Except for the massive leap in M4 lending to the non-financial sector between March and April 2009 (an increase of more than £87bn), it looks as though the UK monetary authorities have been pushing on a string. I look forward to hearing the story behind the Great Leap Forward in M4 lending of March-April 2009; my guess is that it involves some government transaction or government-prompted transaction rather than a great leap in lending to the private non-financial sector.
The incremental money multiplier (not shown) was almost always less than 1 and sometimes negative since March 2009. The average multipliers, shown in Chart 4, keep on falling.
The story of ineffective quantitative easing told by Charts 1 to 4 is confirmed by Chart 5, which shows the relationship between the Bank of England’s official policy rate, Bank Rate, and two measures of the overnight interbank rate, the Sonia – Bank Rate spread (which is for unsecured lending) and the GC rate (Gilt repo rate) – Bank Rate spread, a secured lending rate.
The Bank of England’s official objectives for its sterling money market operations are as follows:
“The Bank’s sterling market operations have two objectives, stemming from its monetary policy and financial stability responsibilities as the UK’s central bank:
- Normally, 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 intra-day volatility in market interest rates at maturities out to that horizon.
- to reduce the cost 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 Bank gives itself some wriggle room by not specifying whether is is the secured or the unsecured overnight interbank rate or both that it wants to maintain in line with Bank Rate. With much of the UK banking system still under-capitalised and wonky, the two can differ by quite a margin, as is clear from Chart 5. At least in the good old days before the Great Financial Kerfuffle, it was the unsecured overnight rate that was generally thought to be the rate the Bank of England wanted to keep in line with Bank Rate. It has been systematically below Bank Rate since quantitative easing began, consistent with the view that there is massive excess liquidity in the system.
The secured overnight lending rate has also been below Bank Rate since QE began, although by less than the unsecured overnight lending rate. Note that Bank Rate is at 50 bps and the interest rate on the standing deposits facility (reserves) stands at 25 basis points. The unsecured overnight interbank rate has hovered at the deposit rate recently. The fact that the UK banking system manages to produce an equilibrium in which the secured lending rate is higher than the unsecured lending rate must be a source of pride to those managing the system. Set this conundrum as a question on your Intermediate Finance exam.
What is to be done?
Two things can and should be done immediately by the bank of England.
(1) Stop Quantitative Easing; start Credit Easing. I fail to understand why the Bank of England is wasting the £175 bn elbow room it has in the Asset Purchase Facility by purchasing government securities rather than private securities outright. There are no anomalies in the government bond markets that would be addressed effectively by large-scale Bank of England purchases of gilts. IF anything, government real and nominal yields at maturities of 10 years and over seem abnormally low. If I had no other use for the APF, I might perform a nice deed in the naughty world of the Chancellor by monetising government debt on a scale that is unprecedented in peace time. But there are other things I could do with the Facility.
Why not invite the issuance of a large volume of covered bonds (Pfandbriefe) by announcing that the Bank of England will purchase, say, £ 40 bn worth of them? Even the ECB is doing it! “Between 6 July 2009 and end-June 2010 the Eurosystem central banks will purchase eligible covered bonds with a targeted nominal amount of EUR 60 billion. ” As of 24 September 2009, € 24 billion has been purchased by the Eurosystem under that facility. It is true that the Euro Area is larger than the UK economy, but non-bank financing plays a much more significant role in the UK (and the US) than in the Euro Area.
Penalise banks holding excess reserves with the central bank
There is a simple way to discourage banks and building societies that borrow from the Bank of England and, rather than lending these funds to households and non-financial enterprises, stick it right back into the Bank of England as reserves. That solution is to pay a low or negative rate of interest on bank deposits with the Bank of England, or at any rate on any reserves held above some minimum threshold to be decided by the Bank of England – let’s call these excess reserves. The Riksbank, the Swedish central bank and the oldest central bank in the world, pays -25 bps on excess reserves. With Bank Rate at 50 bps, I propose that excess reserves be remunerated at a rate 100 bps below bank rate, that is, at -50 basis points. If that does not do the trick, keep reducing the rate on excess reserves until the banks cry uncle and start lending.
Who decides on the spread between Bank Rate and the rate on reserves or on excess reserves: the Monetary Policy Committee (MPC) or the Bank’s Executive? In an answer to this question, the Bank stated “The structure of the sterling monetary framework is formally a matter for the Bank Executive”. That may or may not be true as regards the ‘structure of the sterling monetary framework’ – as Mandy Rice-Davies would have said, “Well, they would, wouldn’t they”. Nothing is written down in laws or binding regulations in that regard. It reflects conventions established before there was an MPC, so that jurisprudence is hardly relevant.
However, the point is irrelevant because we are not talking about the strucuture of the sterling monetary framework, especially the Redbook but about setting a particular rate within that framework, the rate paid on (operational) standing deposit facilities. As the Rebook states “Standing facilities. Standing deposit and (collateralised) lending facilities are available to eligible UK banks and building societies. They may be used on demand. In normal circumstances they carry a penalty, relative to the official Bank Rate, of +/- 25 basis points on the final day of the monthly reserves maintenance period, and of +/- 100 basis points on all other days.”
Clearly, this procedure was overridden when Bank Rate got close to zero, as explained in the Bank of England’s publication “The Development of the Bank of England’s Market Operations”, in October 2008, “For the Operational Standing Facilities, the maturity will remain overnight and the rate will on all days be ±25 basis points relative to Bank Rate.” The MPC should take the decision to raise spread between Bank Rate and the operational deposit facility overnight rate to 100 basis points or more again, for all reserves in excess of some minimal required reserve set by the Bank which is remunerated at Bank Rate. That decision is a monetary policy decision par excellence. It can therefore be taken only by the MPC. They should have set the rate on excess reserves at -0.5% at the last MPC meeting. Having failed to do that, they now should do it at the next meeting, or earlier if possible.