Bank of England review may raise bar for future QE :Mike Dolan

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LONDON — Britain may be the first country to try to consign the once extraordinary monetary policy of bond-buying ‘quantitative easing’ to history – but it may also risk tying its own hands in an unpredictable era of serial shocks.

With the ruling Conservative Party set to select a new prime minister next month, front-runner Liz Truss and her team have loudly criticized the Bank of England for its handling of the global inflation surge and called for a review of its overall mandate and independence.

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With the BoE’s own public polling earlier this year showing popular satisfaction with its performance at a record low, the move is clearly seen as an electoral asset for now.

While a lot of what’s said during leadership campaigns is often just politicking that gets left on the hustings, investors are taking seriously the pledges to review the BoE’s remit and have already started to game possible outcomes and impacts.

To be sure, financial markets – faced with soaring energy prices, double-digit inflation, a looming long recession and rising interest rates – have had other fish to fry of late and have been relatively calm through the contest so far.

But given the Bank of England’s central role tackling many of these pressing economic problems, rethinking its policy parameters comes at an unnerving moment – not least because the direction and desired outcomes are far from clear.

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Deutsche Bank, for one, assumes a review could be announced as soon as next month, after the new prime minister is announced, and be completed early next year.

In a report on Wednesday of the options on the table, Deutsche’s chief UK economist Sanjay Raja reckoned a radical redirection of the central bank’s operational independence or inflation target was unlikely but felt some tweaks were in store – not least in stiffening the criteria for any future bout of QE.

Extensive use of QE bond buying to stabilize markets and cut long-term borrowing costs when policy rates hit zero has been politically controversial around the world ever since the U.S. Federal Reserve and BoE rolled it out to ease the effects of the global banking crash 14 years ago.

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Advocates see it as an essential additional tool for central banks faced with risky policy limits during extraordinary times. But it’s also been decried – mostly by monetarist economists – as simple money printing that distorts financial asset prices, underwrites otherwise unsustainable government borrowing, debases currencies and ultimately unleashes inflation.

Even though inflation fears proved unfounded for more than a decade, it’s little surprise QE – which has always needed a sign-off from the UK’s finance minister anyway – is once again back in the crosshairs in Britain as inflation heads for double digits for the first time since the 1980s.

TOOL OF LAST RESORT

The BoE, whose 844 billion pounds of bonds on its balance sheet contain about 45% of all outstanding UK government bonds, already accepts the need to unwind this.

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Earlier this month it became the first major central bank to announce active sales of bonds to the tune of 10 billion pounds a quarter – rising to about 40 billion pounds when added to the roll-off of maturing bonds.

Now keen to rely on official interest rates for policy direction, BoE deputy chief David Ramsden told Reuters this week he sees a likely secular reduction in the balance sheet that should not tighten financial conditions in itself and that bond sales could continue even if policy rates were cut again.

The speculation, however, is that a new government review of the central bank’s mandate – the second since the Bank of England Act 1998 gave it operational independence and set its inflation target – will make it harder to ever return to QE.

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“We think the bar for any asset purchases going forward could end (up) being higher – especially with mounting skepticism around the impact of QE on growth and inflation,” said Deutsche’s Raja, adding this may see Treasury officials limiting QE to being “a tool of last resort.”

“In a potentially more aggressive outcome, it’s possible that QE may be relegated as a tool geared solely to dealing with market dysfunction rather than in supporting the Bank’s price stability mandate.”

Could this mark the end of an era for QE worldwide?

The UK is a bit of an outlier in this regard and sustaining such a bloated balance sheet in times of rising interest rates potentially increases overall public indebtedness.

Unlike other central banks, the interest rate the BoE pays on commercial bank reserves created in exchange for buying bonds is its own policy rate – and ultimately Treasury is on the hook for this because it indemnifies any BoE losses. This has both increased disquiet about the relationship between the BoE and Treasury and hastened moves to unwind the bond stash.

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UK markets appear to have been well prepared for this “quantitative tightening” and have weathered the BoE review speculation well so far. But the risk of any change to emergency parameters going forward, or indeed to more fundamental aspects of the BoE mandate, may make it an even edgier winter for investors than it already promises to be.

Raja at Deutsche thinks QE will not be completely killed off and currency and bond markets seem well priced for it.

But he said no investor will be completely comfortable with the sidelining of a major policy tool. “Raising the bar to do QE is ultimately a net negative, as you’re effectively constraining the MPC (Monetary Policy Committee) in delivering its objectives.”

The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own

(by Mike Dolan, Twitter: @reutersMikeD; Editing by Paul Simao)