Good luck reversing our addiction to the central bank printing press

The Bank of England has serious questions to answer on how it plans to control inflation

‘A rise of one percentage point in interest rates would add some £20.8bn a year to debt servicing costs’

Many of us will by now be off on our summer holidays but there is no rest for the wicked; when announcing their latest set of economic forecasts this week, there are some hard questions that policymakers at the Bank of England need to answer on inflation, interest rates and quantitative easing.

First and foremost, the Bank must explain and justify in much greater detail than we have seen to date why it thinks the current inflation overshoot is “transitory”. With CPI inflation now widely expected to reach something close to 4pc by the end of this year or early next year, its explanation must include an analysis of why the forecasts failed to anticipate it.

Second, policymakers need to spell out exactly what they intend to do should they again be wrong, and the inflationary pressures prove more persistent than predicted. Will they be seeking to tighten policy by raising Bank Rate, will they be attempting to reverse QE, or perhaps they plan other means entirely, by for instance cracking down on mortgage lending so as to cool an overheating housing market?

Third, a much better explanation and justification of the £450bn of asset purchases (QE) being undertaken to mitigate the economic consequences of the pandemic needs to be provided. Rightly or wrongly, QE is now almost universally seen in markets as little more than straight deficit financing; if it wants to continue using this tool, the Bank needs to provide a convincing alternative explanation.

And finally, precisely how does the Bank plan to begin unwinding QE, thereby reducing the size of its balance sheet? Without better answers, the Bank will soon find itself with a serious credibility problem.

Or as the House of Lords Economic Affairs Committee put it in a recent report, Quantitative Easing; a Dangerous Addiction? – “If negative perceptions continue to spread, the Bank of England’s ability to control inflation and maintain financial stability could be undermined significantly.”

The root of the problem has long been not so much interest rate policy, as what is crudely known as “money printing”. QE first came into vogue during the financial crisis more than 12 years ago, when it was widely credited with helping to save Western economies from a repeat of the Great Depression.

But in the intervening years nothing was done to reverse it; even the suggestion that it might be terminated would result in market panic, as occurred during the May 2013 “taper tantrum”, when Ben Bernanke, then chairman of the US Federal Reserve, hinted at winding the programme down.

Then came the pandemic, prompting a further round of asset purchases. By the time this has been completed the Bank of England’s balance sheet will have been swollen to a size equivalent to roughly 40pc of GDP.

The upshot is that both the Government and the Bank of England find themselves in a perilously exposed position. QE has become an addiction that the Bank of England desperately needs to kick if it is to maintain the flexibility needed to control inflation with higher interest rates.

Some explanation; when the Bank of England buys long-dated gilts, it pays for them by creating its own liabilities in the shape of central bank reserves. The effect is to swap the rate of interest the Government used to pay on its debt issuance for what the Bank pays on reserves, currently set at a negligible 0.1pc. This has been extraordinarily helpful in mitigating the costs of Covid-related deficit spending, significantly decreasing debt servicing costs even as the size of the national debt mushrooms. The consequent saving to the Government already exceeds £100bn.

But what it also means is that if and when the Bank wants to raise its official policy rate to tackle inflationary pressures, the cost to the Government ratchets upwards. The relatively long maturity profile of Britain’s public debt used to be thought of as one of the country’s big financial strengths. But this has been obliterated by QE, reducing the average maturity from around 11 years to something nearer four.

In any case, the Office for Budget Responsibility has estimated that a rise of just one percentage point in short and long-term interest rates would add some £20.8bn a year to the Government’s debt servicing costs, equal to 0.8pc of GDP.

Ministers could, of course, defuse the problem by simply ordering the Bank not to pay any rate of interest on reserves, as was once the case, or alternatively as suggested by the former Financial Services Authority chairman Adair Turner, paying interest only on a capped amount of reserves. Unfortunately, the effect of such a manoeuvre would merely be to transfer the notional cost of the debt to the banking sector, which is required to hold a proportion of its deposits as reserves for regulatory purposes. As one banker put it: “We are already struggling with ultra-low interest rates. This would entirely kill us off.”

It would also look so much like the “fiscal dominance” of old that all pretence at central bank independence would go up in smoke. In other words, it would be a truly desperate move, that ministers would only consider if the public finances reached an unsustainable footing. By signalling such a state of affairs, it would therefore most likely prove ruinously counterproductive.

Indeed, it would only really make sense if you think inflation is no longer a significant risk, and that the main purpose of a central bank is therefore to oil the wheels of fiscal policy. Unwise to bet on it. Just because inflation has been low for a long time doesn’t guarantee it will remain so.

In a recent paper, the National Institute of Economic and Social Research suggested that one way off the QE treadmill would be to swap the Bank’s accumulated holding of long-dated gilts for much shorter dated securities, which would be easier to sell and therefore enable the Bank to begin the process of reducing its balance sheet. Yet it still wouldn’t help the Government much if and when the Bank deems it necessary to start raising interest rates.

The Bank plans to publish a paper dealing with some of these issues alongside of its Monetary Policy Report this week. Might it have found some way through the quagmire? Don’t hold your breath.