On both sides of the Atlantic, central bankers are faced with the unenviable task of hiking rates into a possible recession. The higher rates go, the greater the risk that the Federal Reserve and the Bank of England control inflation at the expense of jobs.
There is, however, a (partial) solution: using their bloated balance sheets — swelled by financial crisis and pandemic crash-fighting as an alternative to blunt interest rate increases.
After all, quantitative easing was used to stimulate economic conditions after the financial crisis and the pandemic. So why not actively use the balance sheet now as a means of tightening things? It might result in price stability with lower short term rates than would otherwise be the case.
Interestingly, that seems to be what the Fed is doing, while the BoE appears to shun the idea. Why?
As a central disclaimer, nobody actually agrees on how QE works, let alone its scary sibling “quantitative tightening”. But it does seem at least theoretically possible that central banks could use QT to do so some cooling through reverse “wealth effects”.
While no central bank has enough evidence to actually outline the likelihood of this sequence of events, the Fed hasn’t been shy in articulating a role for its balance sheet in bringing price pressures back to earth. Take this statement from Fed vice chair Lael Brainard in April:
The reduction in the balance sheet will contribute to monetary policy tightening over and above the expected increases in the policy rate reflected in market pricing and the Committee’s Summary of Economic Projections. I expect the combined effect of rate increases and balance sheet reduction to bring the stance of policy to a more neutral position later this year, with the full extent of additional tightening over time dependent on how the outlook for inflation and employment evolves.
Nobody from the BoE has said something remotely similar, instead, officials there have delivered a series of confusing and somewhat contradictory statements about how the balance sheet fits into its overall monetary policy strategy.
Deutsche Bank economist Sanjay Raja pointed out to FT Alphaville that the BoE has gone out of its way to downplay the impact of its own nascent version of QT. Its August 2021 monetary policy report explicitly stated that while the intention of QE was to impact market expectations of rate paths (a reminder of the long-lost world of “lower for longer”) QT would not have the opposite effect:
First, increasing the target stock of purchased assets may have provided a signal about the MPC’s aim to loosen the overall stance of policy in the past, depressing the expected path of Bank Rate. In contrast, the MPC would not intend to use its decisions about the process of reducing the stock of purchased assets to signal a need for a higher path for Bank Rate.
This, according to Raja, was an effort to “remove a lot of the tightening element” that comes with eventual unwinding. Why is the Fed so much keener to big up the balance sheet as a policy tool than the BoE?
One reason could be the totally different maturity profile of their balance sheets. The Fed’s portfolio is fluid enough to allow a ‘run off’ on different bandwidths depending on the pace with which it wishes to tighten. The BoE doesn’t have this option.
According to FTAV’s calculations, about 20 per cent of Treasuries on the Fed’s books are due to mature next year, and 58 per cent within the next five. That gives it ample room to adjust the extent to which it withdraws liquidity from the market. Along the same time horizons, only 29 per cent of the BoE’s gilts are due to come off its books.
This means that the only way for balance sheet shrinkage to be an active policy tool for the BoE is through out-and-out bond sales. This process would have to be explicitly designed, rather than just adjusting the pace of an already booked-in taper.
The complexity of designing such a program may at least partially explain why the BoE is behind the Fed according to James Smith, an economist at ING:
When the BoE set out their plan for QT in August 2021, they made clear that active sales would be considered when they reached a 1 per cent bank rate. There’s no way that, at that time, the bank would’ve expected to get there within a year. In short, they may just need time to work through the operational aspects of selling.
This interpretation certainly fits with the MPC’s actions last Thursday: tasking bank staff to go away and actually come up with a plan for selling gilts.
We shouldn’t discount relatively compelling technical explanations for the behaviour of central banks. But it would be remiss of us not to point out an alternative, infinitely more interesting argument that puts varying levels of QT-hesitancy down to something else altogether — different levels of confidence as to what it will actually do.
The Fed has been here before. Some economists therefore think Powell and co may just have enough experience to judge how much reduced liquidity markets can handle without becoming distressed. The BoE, on the other hand, has zero experience with QT. This makes the risk-reward profile of its own great unwinding more uncertain.
Jo Michell, an economics professor at UWE Bristol, pointed FTAV towards the harsh truth that the Bank “can’t tolerate” financial markets breaking down via a botched effort at QT. On the other hand, it can pass the responsibility for any rate increase-triggered rise in unemployment to the Treasury.
As interest rates climb, there is nothing stopping fiscal support being delivered to households, pointed out Michell. But would Rishi Sunak be keen to step in here and offer additional assistance? We’re doubtful.
Given the uncertainty as to how the markets would react to out-and-out sales — and the BoE’s mandate to protect both price and financial stability — perhaps QT hesitancy is the correct call.
Our best guess, though, is that if there’s no help from the government, ignoring the usefulness of balance sheet shrinkage as a means to help control inflation might end badly for the BoE.
Source: Economy - ft.com
