Useless QEwats/ QEdiots. Etc.

[spygirl]

QE is entirely theoretical - in a very theoretical i.e. totally made up subjects economics.

BoE is bank. There is nothign theoretical about those.

Banking best practise is known and proven.

Economics and banking should never mix.

FT Alphaville  Bank of England

 

How quantitative tightening *really* works

The world according to BEAPFF

https://www.ft.com/content/c9ccd19c-14dc-4b15-8a21-126a36fdc1d6

After doing a couple of science degrees, Tim Young worked at the BoE, most formatively in market operations, and then as a university lecturer covering finance and monetary economics. He hopes to inspire a new approach of “mechanistic economics” — rigorous from foundational principles, but not unnecessarily mathematical.

Tim would like to thank the ONS and BoE for their assistance.

In November, the Treasury made the first of many payments to the Bank of England to cover a public sector loss on quantitative easing. Despite being £828mn, media coverage of the payment was sparse and often dismissive of its significance, including suggestions that the payment represented merely an internal public sector adjustment, and that losses on QE could be left to accumulate as a meaningless BoE liability. These misunderstandings tend to arise because public knowledge of the operational details of QE, and quantitative tightening, its reversal, is weak.

But such losses do matter, and could be compromising monetary policy choices. Understanding the process sheds light on central banks’ apparent reluctance to tighten monetary policy aggressively in response to the recent surge in inflation.

QE is defined in terms of the quantity of reserves — positive balances in commercial banks’ current accounts at the central bank — created when the central bank buys assets paid for in newly created reserves. In the UK, almost 98% of these assets were UK government bonds or gilts, so for brevity, discussion of private sector bond QE purchases is omitted here. Only commercial banks can hold reserves, so if the central bank buys from a non-bank private sector (NBPS) seller, it makes payment by crediting the reserve balance of the seller’s bank, which in turn credits the seller’s bank account to the same amount. Note that this means that, to the extent that the central bank bought bonds held by commercial banks, QE expands deposit money less than reserves.

Reserves generally bear interest at the central bank’s policy rate, in the case of the BoE known as “Bank rate”.

Uniquely in the UK, public confusion has been exacerbated by the fact that QE/QT, while controlled and executed by the BoE, has been done on the books of a special purpose intermediary, the Bank of England Asset Purchase Facility Fund Ltd (BEAPFF), a subsidiary of the BoE. In other words, the BoE transacts as an agent of the BEAPFF, with QE/QT counterparties settling their trades with the BEAPFF.

The BEAPFF pays for bonds purchased under QE using a Bank-rate-bearing loan from the BoE, increased in step for each purchase, and the bonds are held by the BEAPFF. By agreement between the BoE and HMT, the beneficial owner of the BEAPFF is HMT. This arrangement insulates the BoE balance sheet from profits and losses made on QE, in the latter case effectively granting the BoE an indemnity. Moreover, since 2012, profits and losses made by QE have largely been remitted to HMT, keeping the BEAPFF equity close to zero. This flow of transactions is depicted in the diagram below. Hereafter, this article discusses BoE QE/QT operations, but my account can be applied to other central banks by consolidating the BEAPFF into the BoE.

As the BoE wanted QE to expand deposit money, the BoE deliberately sought to buy the longer-dated gilts typically held by long-term savings funds.

Various public sector bodies, including HMT and the BEAPFF, have current accounts at the BoE but these balances are not classified as reserves, so payments between either of those and the private sector change the stock of reserves.

Like practically all central banks, the BoE’s beneficial owner is its government, meaning that all the BoE’s liabilities and assets, and any net losses and profits its balance sheet generates, are ultimately owned by the taxpayer. Thus, reserves are effectively public sector debt, so when a gilt holding is purchased under QE, there is initially no effect on the market value of public sector debt. Naturally, QE does effectively switch some of the funding of the public sector debt from fixed-term, fixed-rate gilts to perpetual floating-rate BoE debt, though.

Once the BoE has purchased gilts on behalf of the BEAPFF, and the BEAPFF has taken on a loan of equal value from the BoE to make payment to the private sector counterparty involved, thereby creating reserves, the BEAPFF begins to generate cash through-flow. Cash is drawn into the BEAPFF from gilts coupons and redemption payments. To make these payments, the government procures cash from taxation or borrowing, generally sourced from bank deposits and thereby eliminating reserves and deposit money. Meanwhile, the BEAPFF passes cash out to the BoE in interest due on the loan from the BoE, and in turn the BoE pays the interest on reserves to the banks, recreating reserves, which the banks may pass on to depositors, thereby re-expanding deposit money.

The cashflows due to be paid into the BEAPFF by bonds purchased are fixed over the bonds’ remaining life, including a string of coupon payments and a redemption payment at maturity. The yield-to-maturity represents a blended return of the coupons and the amortised change in value of the bond between purchase and maturity, so provides a guide to the return locked-in at the time of purchase (“guide” because the cashflows generated by the bonds are lumpy). The price paid determines the quantity of reserves created to pay for the holding and the value of the addition to the loan from the BoE to BEAPFF that funds the purchase. Naturally, the Bank rate (of interest) paid on the loan fluctuates according to monetary policy, generating a variable flow from the BEAPFF to the BoE. Thus, in general, the bond and loan interest flows into and out of the BEAPFF will not net out.

Over the BoE’s QE programme, bond purchases (now ceased) have mostly obtained yields above Bank rate, , until recently, QE has generated net interest income for the public sector. As per the indemnity agreement, HMT has withdrawn the resulting surpluses from the BEAPFF, and used them either for additional expenditure, or to maintain expenditure and reduce the national debt, both of which the public understand to be of real benefit to them. Alternatively, surpluses could have been retained as positive equity in the BEAPFF, presumably to be invested by buying additional sterling securities from the private sector, without increasing the BEAPFF’s loan from the BoE. Either approach would have held the stock of reserves constant (as required unless the BoE adjusts the policy quantity).

Now that interest rates have been raised to stem inflation however, the net interest income has turned negative, so for the foreseeable future, HMT will be paying cash into the BEAPFF to prevent its equity going negative. Because such deficits have to be covered by increased taxation or borrowing, they will constitute an additional burden on the taxpayer.

When a gilt held in the BEAPFF matures, HMT makes a redemption payment into the BEAPFF, plus or minus, under the terms of the indemnity, any mismatch between that payment and the value of the loan additions used to purchase that holding. In the 89% of gilts purchases made at a price above par, this requires HMT to find additional cash. The payment reduces the stock of reserves, and, as the inflow is netted off the BEAPFF’s loan from the BoE, the BoE’s balance sheet contracts. If the BoE wants to maintain the stock of reserves, it has to buy more gilts on behalf of the BEAPFF, and increase the loan again.

However, it had originally been envisaged that when extraordinary monetary policy easing was no longer needed, especially if inflation looked set to rise above its target, central banks would begin to reduce the large stock of money that QE put into circulation. While this is termed QT, the quantity is not so specifically managed as under QE. QT can be done either passively, by ceasing to disburse or reinvest coupon and redemption income, with the BEAPFF instead using the income to pay down some of its loan from the BoE, leaving the stock of reserves and deposit money somewhat reduced. Alternatively, if the central bank wishes to accelerate the process, it can do so by actively selling bonds, which as inflation has recently surged, the BoE is tentatively beginning to do. Again, HMT covers any mismatch between the value realised and the value of the loan to fund the bond’s purchase.

With BEAPFF bond holdings now generating cashflow deficits, it might be supposed that active QT would be a good way for the BoE to tighten monetary policy to tackle rising inflation. What makes active QT awkward for the BoE, however, is that throughout its QE programme and especially during the pandemic, gilts purchases mostly locked in yields around all-time lows, funded at monetary policy rates that, albeit generally lower than the bond yields, were also around their all-time lows, with plenty of upside, if only just towards “normal”. Since monetary policy rates have risen, with bond yields having risen in anticipation of a long period of higher monetary rates, active QT would crystalise embarrassingly large losses.

 

Given that the average yield on gilts purchased under QE was about 1.5 per cent, including half of the gilts held when QE reached its maximum size of £875bn purchased during the pandemic at an average yield of about 0.5 per cent, compared with a normal Bank rate of, say, at least 2 per cent, and given that the average remaining life of gilts in the BEAPFF is about thirteen years, it seems very likely that, over its lifetime, BoE QE will realise a total loss in the order of £10bns, if not £100bns. Surpluses generated when monetary policy rates were low will almost certainly be exceeded by later deficits.

There is no monetary policy imperative to remove reserves by active QT, provided that the interest rate paid on reserves is always sufficiently rewarding for banks to be content to hold reserves. If a below-market rate of interest is paid on reserves, although banks are collectively stuck with the reserves created by monetary policy, individual banks can be expected to try to offload reserves by buying things, most obviously loan assets, meaning lending, which would be inflationary. However, assuming that Bank rate is set to deliver the BoE’s inflation target, Bank rate should be a roughly fair market rate.

This suggests that, for the BoE, an attractive alternative to active QT might be passive QT, holding the gilts to maturity. Unfortunately, while this might spread QE losses over time (the average remaining life of the gilts in the BEAPFF is over thirteen years, with the longest maturing in 2071) and make the losses less noticeable, this cannot be cannot be relied upon to be better for the taxpayer. Key to understanding why not is the normal working assumption that fixed income markets are efficient, meaning that government bond yields discount the expected (in the statistical sense) path of monetary policy rates. This implies the same expected loss, with the eventual loss as likely to be larger as smaller.

Another idea mooted is that central banks should simply create more reserves to cover any net interest cost on QE, and run negative equity indefinitely, in the belief that central bank liabilities are meaningless because they can always be serviced by creating more of them. In the UK this would require the indemnity to be cancelled, assuming that the BoE would agree to it. The reason why running negative equity does not help is, again, that the interest cost involved can be expected to more or less equal the loss realised by QT, and since the central bank’s beneficial owner is generally their government, it makes no financial difference where the loss is incurred.

The only sure way to decrease the losses on QE is for the central bank to pay less than a fair market rate of interest on reserves. As noted above, this would be inflationary.

Perhaps banks could be paid less than the monetary policy rate on all but a marginal amount of their reserves holdings, and to prevent inflation, be compelled by the authorities to hold at least that quantity of reserves. The trouble with such a scheme, which would be effectively a tax on banks, is that the banks might pass the tax on to their customers, probably constituting, given the type of customers who typically incur bank charges, a regressive tax. Moreover, such a measure is arguably immoral, given that the banks will have mostly involuntarily acquired an arbitrary amount of reserves through settling payments made to their customers. It would damage trust in the central bank, making it more difficult for monetary policy to ever use QE again, and could even undermine the payments system.

With no painless solution to the problems raised by tightening monetary policy after QE, one can imagine that this is a reason why policy makers seem to be dragging their feet over tightening.

 

[spygirl]

Comments -

Excellent piece and agree good to see Tim as a columnist..

 

However, he must also realise that QE is understood by neither the public or parliamentarians, which is why it has been the policy tool of choice..bail out bankers and enrich some at the expense of others while by-passing democracy almost entirely..

 

This has of course and will continue to cause all sorts of societal, political and economic ills

That is the point of this explanation. I am not aware of any account with the kind of comprehensive detail that I have tried to include here. The idea is that, if and when the issue gets discussed, as it might well do when some of the losses on QE are large enough to attract media attention, there is an aid to discussion available that can help to dispel misconceptions.

 

Actually, to be fair, the Parliamentary select committees have taken a close interest in QE, but they mostly take "evidence" from the policymakers more than the engineers, and the danger is that that is a bit like asking Lewis Hamilton how his engine works.

Very little interest and understanding by Parliament when it first occurred - I requested of Andrew Tyrie 4 times (as Treasury Select Committee Chairman) to ensure debated properly and there was a distinctly low interest in any transparency or debate

Interesting. I thought Andrew Tyrie was very much on the case. I also wrote to him, but never got an answer, because he was ousted as Treasury Select Committee chairman.

Nope, his team even called to say, we acknowledge your questions and points but have no intention of answering them or doing anything about it, implying it was all a bit tricky and best not to

At least you got a call...I never even got an acknowledgement!

Do you think anyone has noticed that you can use jam jar accounting to good effect if the counterparties are truly independent entities but when both jam jars are in the same bottle bank creating a third jam jar snappily called "Bank of Bottles Subsidiary Jam Jar Ltd" adds to complexity without addressing the underlying flaws in the structure which you have exposed?

 

I suppose when the left hand doesn't know what the right hand is doing grafting on extra fingers creates the illusion of control?

 

Cynicism aside, how is this byzantine structure an alleged improvement on controlling the inflation and liquidity in the economy through fiscal and monetary policy a la Thatcherism circa early 1990s?

 

Great article - I hope they paid you and can persuade you to write more.

Actually, it is quite a cunning plan, because it ensured that the effect of QE on the BoE balance sheet was completely matched - Bank rate in, Bank rate out - so no issue of negative equity of the BoE should arise as the result of QE, and no need for recapitalisation by government, as some QEing central banks will probably need.

 

I don't this structure has much to do with controlling inflation. QE was largely about boosting nominal economic activity when inflation just did not seem to be a constraint. The trouble with QE, and indeed extreme easing before that, I would argue, is that monetary policy makers have tended to live for the day, and not plan for an exit strategy.

 

I don't expect to get paid, but I guess I am now part of the FTA's "creator community" or something like that.

"QE was largely about boosting nominal economic activity" - or was it just about inflating asset prices?

A bit of both. The rationale for QE, or at least the emphasis on reasons, evolved during the time that QE was accumulating, but part of that rationale was about holding down longer term credit-risk-free interest rates and longer-term returns generally, with the aim of encouraging investment spending, and naturally a corollary of that is that asset prices rise (via lower discount rates, rather than the income from assets) rise, and that produces a wealth effect which empirically boosts consumption spending too.

We had inflation, they just didn't include land price inflation in the stats.

QE was largely about boosting nominal economic activity when inflation just did not seem to be a constraint.

Sorry I wasn't clear. My point is that negative interest rates would have done that in a more straightforward way.

 

Why, in your opinion, did Central Banks prefer an ill understood untested mechanism to a traditional approach?

I agree entirely. As you may have seen me mention in FT comments before, it seems common sense to me that assets have value because they provide what I call "wherewithal to consume", by which I mean not just cash, but consumable services, like shelter from a house (which of course requires land), so it also seems common sense that asset prices and consumer prices are tied together, albeit elastically. That suggests to me that central banks, at least as far back as the 1990s were bound for trouble when they chose to ignore asset prices. And, while it may have been expedient for central banks to say that asset prices are not in their mandate - expedient because asset owners tend to protest when the authorities take measures which hold asset prices down, as Greenspan found after making his famous irrational exuberance remark - if my logic is correct, they could have asserted the long-run link I describe to justify leaning against asset prices.

 

I did write a note recording this argument back in March 2000 when I was still working at the BoE, but the note did not get much interest.

Earlier on during QE, central banks were wary about what might happen if they set their policy rates really close to zero. Remember that, while people talk glibly about "interest rates", there is a lot more detail in it than that. The policy rate is normally the rate set on open market - mostly repo lending - operations for a term of a week or , which commercial banks may or may not take up, and there are marginal facilities around the central policy rate, including overnight deposit and lending facilities. And then there are the interest rates at which banks borrow and lend to each other in the inter-bank market (which are always of great interest to monetary policy makers, and in the Fed's case actually define its policy rate).

 

One thing that central banks want to avoid is becoming a kind of central counterparty in the inter-bank market, so they need to maintain a spread between their marginal facilities. Also, reserve balances must be freely convertible into banknotes, meaning that, if the deposit rate is set too negative, it becomes economic for banks with excess reserves to instead buy banknotes and hold them in their vaults. The deposit rate that would prompt that activity was considered to be something like -¾%. , that minimum feasible deposit rate, plus the need for a spread between the marginal deposit and loan facilities, more or less determined how low policy rates could go. So when Bank rate had been lowered to ½% in March 2009, the MPC considered that to be about the lower bound, and turned to QE, effectively meaning operating at longer-term interest rates.

 

After QE had created a large stock of reserves, the feasibility of wholesale swapping of reserves for banknotes reduced, so central banks were able to put their policy rates a little lower, but not much lower - the low point on Bank rate was -0.1%. Also more heavy-handed central banks than the BoE simply set a limit on the use of their deposit facility to force market rates even lower.

QE is understood by neither the public or parliamentarians

I wonder if Kwasi understands it yet? He looked very confused throughout his brief tenure!

 

The bloated stock of QE surely reduced even further the room for his fiscal manoeuvres; he clearly didn’t understand the tightrope the BOE was already walking.

I second that 100%.

Thanks Tim.

QE is understood by neither the public or parliamentarians

That is of course a feature rather than a bug.

(Edited)

Congratulations Tim.

FT finally asked you to write after ignoring your letters for years :-)

Tim’s comments are often better than the article they are on, delighted to see a full column from him.

FT

Apologies, we seem to be having a problem with the images on this article. FTAV’s brightest and best are working on it, so don’t get your hopes up for a quick fix… 👷

FT

Hopefully all should be working again now.

Excellent piece. Overdue. Thanks.

The BoE didn't do QE to make a profit, they did it to drive down gilt yields in the belief this would create a wealth effect from lower risk free rate.

The BoE didn't raise interest rates faster in the face of 10% inflation because they knew that this would crash the housing market.

Totally agree with both points

(Edited)

Tim, thank you! I always value your insightful comments on articles and I am going to attempt to understand approximately half of this article, after multiple readings!

A very important topic that has affected everyone for better or worse over the last 15 years.

Great to see your name at the top of the page for a change. Thanks again.

Thanks for your appreciation.

It's a disgrace that it's taken this long for the FT to publish and article of this type

 

(I'm assuming it's right Tim!)

That's a little harsh!

Yes, perhaps a little harsh. A hurdle to getting this published has been that too many people simply dismiss the potential for central banks to sustain losses as not meaningful, but apparently without feeling the obligation to go into the detail to check their opinion.

 

I do agree, however, that there is a case for more of these "explainer" articles, ideally fairly early as an issue grows in prominence and if possible, written in close collaboration with the people close to the detail, comprehensive and attempting to anticipate and answer likely questions. Because there is a danger that everyone assumes that everyone else interested knows the details, when in fact that is not the case. I felt that was particularly the case with the LDI debacle, which was outside my expertise, but which I scrambled to learn about having been approached for a comment by a journalist. Even now, when I am pretty sure that key to understanding those events was that the defined benefit pension funds were using agents to manage their interest rate hedges, you still get people saying that the pension funds themselves were, say, five times leveraged, "...and that is a disgrace!".

(Edited)

How many journalists, even business journalists in the supposed broadsheet press (excluding the FT!), are sufficiently technically able to hold the government to account on our behalf? When the prime minister and chancellor (you know who I mean) and to be honest, the entire cabinet of government, has not even a rudimentary understanding of the gilt market, someone somewhere needs to shout “what are you doing?”

Will have to read this one later. Thanks for the article.

 

I take an active interest in macroeconomics and central banking and struggle with the monetary magic of QE so doubt that >90% of the population have any idea about it. And who can blame them it’s complicated and boring.

Thanks for this. I'll let you know what I think about it once I've finished these two textbooks.

There's a comedic opportunity here.

Silent movie. Laurel and Hardy lookalikes. Big fat man (sorry rotund) wears a long, dirty mac with many, many capacious pockets. He's wearing a bowler too, of course. The pockets are variously labelled BoE, HMT, BEAPFF etc etc.

 

Then at (very) high speed, with suitable silent movie piano music, thin man (taxpayer?) hands fat man (the Gov't, financial sector) a thick wad of 50 quid notes and then the pounds are moved from pocket to pocket along with pratfalls, slapstick slaps and hundreds of notes fluttering in the air.

 

QE/QT in action, UK style!

Britain's richest 5% gained most from quantitative easing – Bank of England

The richest 10% of households in Britain have seen the value of their assets increase by up to £322,000 as a result of the Bank of England's attempts to use electronic money creation to lift the economy out of its deepest post-war slump.

Threadneedle Street said that wealthy families had been the biggest beneficiaries of its £375bn quantitative-easing (QE) programme, under which it has been buying government gilts for cash since early 2009.

The Bank of England calculated that the value of shares and bonds had risen by 26% – or £600bn – as a result of the policy, equivalent to £10,000 for each household in the UK. It added, however, that 40% of the gains went to the richest 5% of households.

However, Threadneedle Street said that QE had helped all sections of the population by sparing the country from a deeper slump. The rise in asset prices after QE was announced in early 2009 followed sharp falls in the two previous years.

"Without the Bank's asset purchases, most people in the UK would have been worse off," it said in a paper prepared in response to queries from the Commons Treasury committee.

"By pushing up a range of asset prices [such as equities and bonds], asset purchases have boosted the value of households' financial wealth held outside pension funds, although holdings are heavily skewed with the top 5% of households holding 40% of these assets."

https://www.theguardian.com/business/2012/aug/23/britains-richest-gained-quantative-easing-bank

And then they did it all again x2 and don’t unwind with quite the same verve..

 

People on the street don’t know why the world/system isn’t working for them - but they know it isn’t.

 

Which makes it so dangerous - and hence all FT whingeing about Trump, Brexit etc is weird

Trump is the perfect lightning rod

And the government is still wondering why we’ve all retired early!

I need a lie-down. Feel like the famously bemused contestant on 3-2-1 who looked at Ted Rogers in mounting panic when he gave her the insanely complicated answer to the unanswerable riddle to win a cruet set or somesuch. Will steel myself to give it another go. As ever, erudite comments on here help.

If you collapse all this complexity, it seems simply that this government vehicle has borrowed short to invest long bonds and is now caught out by the rise in interest rates. But for the vehicle’s access to effectively unlimited liquidity, it would be in a pickle. (Pooled LDI fund parallel!) From the government’s point of view it looks like a fixed to floating swap on a portion of its liabilities. Is this right?

Absolutely

Yes, you are right that this is like an asset swap - as I write in my ninth paragraph. Perhaps it was not a good idea to switch from paying fixed to paying floating interest rates when long-term fixed interest rates were around their all-time lows.

Good stuff. Trying to get my head around this: if, a big if, BoE were to simply allow the book to run off (ie let the bonds mature) would that be a solution to the P&L conundrum?

No, if the gilts market is efficient, letting QE roll off over time is as likely to end up with a bigger loss as a smaller one, although being spread out would make the losses less prominent - see my last paragraph but four.

 

However, while it is not a "solution", I would admit that empirically, yield curves do tend to slope up when averaged over a long time, which would suggest that, unless active QT is useful for monetary tightening purposes, passive QT would be a marginally better choice. That is an issue that I could have covered but the explanation was long enough as it is!

What makes active QE awkward for the BoE, however, is that throughout its QE programme and especially during the pandemic, gilts purchases mostly locked in yields around all-time lows

I believe "active QE" was meant to say "active QT" in the above?

 

Great article, hoping we get to see more of this. And looking forward to the charts.

Correct. I will ask FTA to fix that, thanks.

FT

Fixed, thank you for catching!

I seem to have fallen at the first hurdle

Can anyone explain this line?

QE expands deposit money less than reserves.

I think it's related to the fact that the BoE tends to buy more assets from commercial banks than non-bank private sector sellers?

"Only commercial banks can hold reserves, so if the central bank buys from a non-bank private sector (NBPS) seller, it makes payment by crediting the reserve balance of the seller’s bank, which in turn credits the seller’s bank account to the same amount."

Thanks for your interest.

 

You missed out the qualification "to the extent that the central bank bought bonds held by commercial banks...". Any purchase made by the BoE is settled by newly created reserves. If, as I would imagine was mostly the case (naturally, the BoE did not publish the identities of its counterparties), gilts were purchased from NBPS counterparties like pension funds and insurance companies, the counterparty cannot hold reserves, so the way that transaction settles is the BoE crediting the seller's bank's reserves account, and the bank in turn crediting the seller's bank account, so the purchase creates the same amount of reserves and deposit money. If a bank already held gilts, and sold them to the BoE, the BoE would credit the bank's reserve account and the chain would end there. Hence QE may create a quantity of deposit money that is a little less than the quantity of reserves (which is how the quantity is defined).

 

Apparently FTA are having trouble with the diagram, but when that gets posted, it should help.

Weren't a lot of the gifts bought in primary auctions - i.e. from the DMO on issue?

Pretty sure that's not allowed. I think QE as we know it is built partly to avoid the impression of "fiscal dominance" i.e. direct central bank funding. But will await input from the guy who knows what he's talking about.

If not, that would essentially have just given the dealers a chance to make a cut by sitting in the middle but otherwise had the same effect as direct purchases, so not good policy IMO!

Just as Landlord's Burden said.

 

If I recall correctly, gilts offered to the BoE in the reverse auctions the BoE conducted in order to buy gilts from the market had to have been in the market for at least a week. The idea of that rule is that there is some transparency about the terms on which, via gilts QE, the BoE is effectively lending to the government. Naturally that is a very imperfect check on the terms, because anyone bidding in the primary auction when the gilts are issued would know that the BoE can be a buyer in the very near term, which would underpin the price achieved in the primary auction. That effect was probably at its strongest during the pandemic QE, when the government were selling a lot of gilts, while the BoE was buying almost at the same pace.

 

In practice, I would doubt that the BoE bought many recently issued gilts anyway, because newly issued bonds generally carry a liquidity premium for a while after issue, which would have been of little value to the BoE, so if such gilts were offered, the BoE would not have lifted those offers.

Hmm, so what I think you're saying is that when the bank's interest rate gets higher, you have to pay more interest on your debt, not matter what convoluted structure you've hidden it in. And QE has only exacerbated this because classically you've exchanged low rate fixed term debt for what is now high rate variable debt.

 

And the only solution to this is to let inflation eat away the value of the debt, so that QE which massively benefitted the rich, is now going to massively disadvantage the poor.

No, inflation is not a solution - for the public at least. You have to believe that the fixed income market is stupid to think that inflation is a solution to public sector indebtedness. Allow me to explain why.

 

If inflation is allowed to rise, with the borrower having revealed their preferences, fixed income markets can be expected to demand higher real interest rates in expectation of more inflation, on all future debt contracts for the indefinite future. That means that, unless the borrower really believes that they can pay off all maturing debt, which would take the mother of all fiscal squeezes, they will have to at least roll over some debt at whatever real interest rates the fixed income market demands. And, for a typical debt term in the order of years, that higher cost will be locked in, even if the market can be convinced that the borrower really does eschew inflation in future.

 

The bottom line is that while inflation may lower the real value of existing fixed income debt, it will more or less fail to reduce the real debt burden for the public, as debt recontracts at higher real interest rates. In fact, it is likely that inflation will, over time, increase the cost of government borrowing. What the public need to understand, however, is that for the incumbent authorities, inflation does reduce the near-term real interest burden, and those authorities may worry less about the longer term, when the real interest burden has increased but they have left office and are no longer responsible for paying it, than the public.

 

As a salutary demonstration of that argument, note that Argentina actually has a relatively low debt-to-GDP ratio: https://tradingeconomics.com/argentina/government-debt-to-gdp , but Argentina certainly does not find its interest burden to be light!

The trouble is our electoral cycle, especially if you expect to lose, incentivises you to take the short term fix and leave the long term pain for others. The BoE seem pretty complicit in allowing this to happen over recent years.

I agree. I was at the BoE, and remember well, the day that the Labour government granted the BoE monetary policy independence. As the news sank in, I felt optimistic that, at last, the days of stoking house prices and engineering booms, with subsequent busts, were over, and the UK could have monetary policy and economic stability like the Bundesbank delivered for Germany. So I have been deeply disappointed at how the BoE has used - or more precisely, declined to assert - that monetary policy independence.

 

Rather than go into why the BoE has behaved in the way it has done, suffice it to say that the BoE decisively failed to take several opportunities to err on the tight side when that was arguably justified, not least to lean against rising popular asset - ie, in the UK, house - prices. Mervyn King dismissed those calling for tighter monetary policy when inflation was way over target in 2011 as "inflation nutters", which might have gone some way towards exiting the extreme easing in response the to financial crisis, while under Mark Carney the BoE went along the the government's help-to-buy scheme, despite it being initially presented as subject to BoE approval, and perversely eased monetary policy in response to the Leave result of the EU referendum, which prompted sterling depreciation that was bound to lead to higher inflation.

Over the course of my working life, and to be honest over any time period in the past 100 years, the chart of sterling goes from top left to bottom right. A few bounces along the way, but the tread is pretty clear. Nothing in your excellent analysis here suggests that is likely to stop. I remember, not so long ago, £1 = Dm4 or Fr10 or $2.40. The Fed make mistakes but I trust them to fix them more than the BoE.

Is the Fed in a similar situation, except needing for US treasury to make the Fed whole (Fed instead running a liability on the losses). Given that they bought bonds with a positive yield curve and will cut rates back to at least neutral, or lower in a recession, is there less of an impact? I am not sure there should be vs BOE, except shorter duration and never selling bonds (only allowing them to mature).

Yes, the Fed is in the same situation, except for (1) as you say the US Treasury has to actively make the Fed whole, and (2) because the average maturity of the US treasury market is about half of that of gilts, for any given percentage of GDP, the Fed's QE portfolio is less exposed to a shift up in the yield curve of any given size. The latter will however by complicated by the fact that the Fed bought some MBS, which have long nominal duration but negative convexity.

I think I'm missing something here.

 

Here's (crudely!) how I think Tim is explaining this situation has arisen:

 

BoE loans BEAFF money. BEAFF uses this to purchase gilts. 2022 interest rate rises mean that loan servicing costs exceed coupons from gilts. HMT is on the hook for BEAFF losses.

 

But what happens to the interest payments back to the BoE? Does that not get sent back to HMT? I dont follow why more public money is needed - where has the money gone as it were?

You are right, HMT makes transfers into the BEAPFF when it makes losses, but took cash out of the BEAPFF in the early days of QE, when gilts purchased at higher yields than Bank rate generated - that cash sweep began in 2012: https://www.bankofengland.co.uk/-/media/boe/files/letter/2012/chancellor-letter-091112.pdf . As the result of those early gains, QE was in profit over its lifetime until sometime last year, but went into loss, at least on a mark-to-market basis, as gilts yields rose.

(Edited)

Boosted by the Truss-Kwarteng moron premium?

Yes, the mark-to-market value of the QE portfolio would have reached its nadir at that time. The BoE postponed their planned active QT though, so they were not adding to the reported selling pressure.

[spygirl]

TLDNR.

QE requires the CB to be an all knowing all seeing able to execute exactly.

If low inflation/rates were down to the CB genius then theres no problems.

If low rates/inflation were just down to, say, China exporting disinflation and the CBs were nothing but a bunch of fuckwits then the CB are in deep deep deep shit as the losses from the QE bond buy looks for someone where to land.

 

 

 

[spygirl]

Same place, similar theme.

Does it matter that central banks are losing squillions?

https://www.ft.com/content/7c99e8f6-2294-43c1-a37d-d01bedcb143d

The QE flipside — red ink everywhere

There have been a lot of red faces in the asset management industry lately, with Tiger Global alone incinerating almost $18bn in 2022.

But you know who really sucks at investing? Central banks.

 

Take the Federal Reserve, for example. Chair Jay Powell had the Fed gobbling up almost every bond in sight ($4.5tn worth) at the start of the pandemic while rates were already close to all-time lows. There was only one way for yields to go. What was he thinking?

Unsurprisingly, the Fed’s portfolio has stunk. The Fed’s last financial update, in September 2022, reveals paper losses of almost $1.3tn during the first three quarters of that year. Since then, 10-year Treasury yields have round-tripped from around 3.5 per cent to 4.25 per cent and back, suggesting the losses may be similar today.

 

 

...

In 2023 the Fed is likely to turn in its first annual operating loss since 1915

[spygirl]

Not cutnpastign this one.

FTAV is free to read if you register.

Fed is still different - any losswill be pushed out into the world trading economy and the CB who hold dollar bonds.

BoE isnt. Any less hcome back to UKGOV one way or another.

 

[spygirl]

Investors dump US bank shares amid fears over value of bond portfolios

Difficulties at Silicon Valley Bank spark biggest one-day sell-off since early months of pandemic

https://www.ft.com/content/47e3d4a7-70b6-4a4e-98b0-6322f8e8ba53

Dumb fucking yanks.

The EU/ECB are much more sophisticated and dont have anywhere near the same exposure as the US ....

Whast that you say ... its worse ...

Its hard to communicate hjow much shit the german banks n state are in at the moment.

Theyve spent the last 10y pumping creit into basket cases.

 

 

[spygirl]

European bank stocks sell off sharply after steep falls in US

Investors offload shares after Silicon Valley Bank reveals $1.8bn loss on sale of securities portfolio

https://www.ft.com/content/7bc37f48-3096-481d-874f-0d8f4db27509