The UK economy has been dealt what the Bank of England says ‘amounts to a small loosening of monetary policy’ following a decision to transfer the income from gilts the Bank bought in its quantitative easing (QE) scheme to the Treasury.
The money, which will amount to some £35 billion by March 2013 – with regular payments to follow – will be used by the Treasury to reduce government debt, but economists are already warning of the long-term consequences of the transfer.
The Bank’s monetary policy committee (MPC), which yesterday voted against extending its bond-buying stimulus scheme beyond the existing £375 billion of money it has created to fund the purchases, said the move would have an effect similar as extending QE by the same amount.
Until now, the money from gilt coupons has been held by the Bank of England, but the move brings the Bank’s policy in line with easing schemes undertaken by central banks in Japan and the US, the Treasury said, while arguing that the previous arrangement was ‘economically inefficient'.
Surprise move helps chancellor hit debt target
Nevertheless the move surprised experts and adds to the increasingly surreal nature of the UK's monetary policy in which the Bank of England has created new money electronically; used it to buy government debt to inject the money into the economy; then transferred the interest it receives to the Treasury; which can use it to reduce the level of its borrowing.
The timing of the transfer provides a short-term boost to the chancellor ahead of his Autumn Statement in December.
Michael Saunders, an economist at Citigroup, said of the plan: ‘The reduction in the debt/GDP ratio may just about be enough for the Office for Budget Responsibility to project that the government will probably hit its target of a falling debt/GDP ratio in 2015/16, whereas previously that appeared out of reach.’
This monetary loosening is, however, likely to be temporary because, as the Bank of England governor Mervy King (pictured) stated in his letter to the chancellor: 'It is likely to lead to the need for reverse payments from the government to the APF in the future as the Bank rate increases and the APF's gilt holdings are unwound by the MPC.'
Saunders added: ‘This may be a key reason why the MPC decided not to expand QE further at yesterday’s meeting.’
Comparison with Zimbabwe
Ross Walker of RBS said that although the transfer announcement is a short-term positive for the UK government's funding operations, 'it will inevitably raise questions/concerns about public debt "monetisation" and, more generally, the relationship between the Treasury and the operationally independent central bank.'
Philip Rush of Nomura echoed this saying the change crystallised the inter-dependence of the Bank of England and the Treasury and risked comparisons with Zimbabwe which destroyed its currency with money printing four years ago.
'Now, whenever the BoE does QE, it will be directly and transparently reducing government borrowing not just through putting downward pressure on yields [which fall as purchases drive up the price of guilts], but through causing all the costs the government faces in issuing its debt to be returned to it promptly each quarter,' he said.
Rush added: 'It is not "Zimbabwean style" monetary financing because any money printed is done so only temporarily, at least in theory, but it looks to us to be a conservative version of it.'
The pound fell 0.4% to a two-month low of $1.5910 against the dollar as markets digested the news.
Will the Bank ever sell the gilts it has bought?
Malcolm Barr of JP Morgan expressed concern that the APF cash pile had originally been viewed as a safety net to offset potential losses when the Bank sells the gilts when economic conditions return to normal.
He said: ‘we were much more comfortable with the idea of the coupon profits sitting within the APF as a buffer, which could soften the scrutiny of the fiscal implications of losses on gilt holdings when monetary tightening was eventually needed.’
The transfer of cash to the Treasury would increase scepticism that the Bank of England will ever sell the gilts it has bought, he said.
Andrew Sentance, a former member of the MPC, warned via Twitter: ‘Monetary policy now has fiscal consequences. When/if BoE unwinds QE, the deficit will look worse!'
Tony Nangle, head of multi-asset allocation at Threadneedle Investments, backed the move, however. 'These coupons are not part of the QE programme and it was made clear at the start of QE that they would always be the property of the Treasury. The Treasury has been able to service its debts and so build up this cash reserve at the Bank by borrowing from the market. This process has been akin to borrowing money with an interest rate in order to stuff it under the mattress.'
Here is a video explaining what quantitative easing is and how it affects people relying on income from their savings