Finding a reverse gear

The Bank of England’s Monetary Policy Report is required reading for those interested in UK macro trends and today’s report was no exception. Listening to some of the media commentary ahead of the report’s release, people might have been forgiven for believing that monetary tightening was imminent. In reality, that was never the case although the BoE did provide some guidance on the sequencing as to how the easing of the policy throttle will occur.

The economic outlook supports lifting the foot off the gas

Turning first to the details, the BoE’s macro forecast suggested that UK GDP will grow by 7¼% in 2021 and 6% in 2022, and only slow to trend (1.5%) in 2023. One implication of this is that the level of output will get back to pre-recession levels by end-2021, which is a far sharper rebound than expected a year ago. As a result the output gap is expected to be almost eliminated this year and an excess demand position is anticipated in 2022 (i.e. a positive output gap). With inflation projected to hit 4% in Q4 2021/Q1 2022, questions have been raised as to whether the current exceptionally lax monetary stance is warranted.

One member of the MPC (Michael Saunders) voted to limit gilt purchases to £850bn (it currently stands at £825bn) rather than press on to the currently mandated upper limit of £875bn. Although the idea of calling a halt before reaching the current target is unlikely to make a great difference in the grand scheme of things, it would send a signal of intent that the BoE is prepared to scale back its asset purchases as circumstances dictate. Indeed, when the MPC announced an expansion of the upper limit for gilt purchases to £875bn in November 2020, inflation was expected to peak at 2.1% in late-2021/early-2022 whilst output was not expected to get back to pre-recession levels until early-2022 (i.e. one quarter later than in August).

As the MPC minutes pointed out, the MPC “had policy guidance in place specifying that it did not intend to tighten monetary policy at least until there was clear evidence that significant progress was being made in eliminating spare capacity and achieving the 2% inflation target sustainably.” Although “some members of the Committee judged that … the conditions were not yet met fully”, it is hard to know what more evidence they need to justify scaling back monetary easing with inflation running at twice the target rate and with the output gap set to close. It is important to stress at this point that I agree with those who believe it is perhaps too early to significantly tighten policy. But this is not to say there is a case for easing off the throttle. On the basis that the stock of assets purchased is more important for policy purposes than the flow of purchases, setting a lower limit for gilt purchases implies a very moderate reduction in the degree of planned monetary easing.

Dealing with tightening

The BoE did indicate that when the time for tightening comes, its preference is to use Bank Rate as the instrument of choice and suggested that “some modest tightening of monetary policy over the forecast period is likely to be necessary.” As the Resolution Foundation has pointed out, this has the advantage of being swift to implement and can swiftly be reversed if necessary. But the BoE also indicated that it “intends to begin to reduce the stock of purchased assets, by ceasing to reinvest maturing assets, when Bank Rate has risen to 0.5%.” This could lead to a swifter unwinding of the balance sheet than might be expected and would go a long way towards assuaging the concerns of those who believe the balance sheet is too big.

To illustrate the impact of this, we start by looking at the details of the debt stock currently held by the BoE (here). We can use this information set to determine the precise maturity date of gilts on the balance sheet and my calculations suggest that the median maturity of gilt holdings is just over eight years. Assuming that Bank Rate reaches 0.5% by end-2023 and does not fall back below this level, allowing all maturing debt to roll off will halve the balance sheet in money terms by 2034. Further assuming nominal GDP growth of around 4% per year in the longer term, gilt holdings would decline from around 40% of GDP in 2021 to 12% by 2034. The BoE may, of course, choose to reinvest a certain proportion of maturing debt, rather than letting it all run off, and the resultant stylised scenarios are shown in the chart below. It is notable that even if gilt holdings remained at £875bn over the longer-term, the GDP assumption used here would be sufficient to reduce the balance sheet relative to GDP back towards 2013 levels even in the absence of any direct action.

In addition, the Bank suggested that it would be prepared to consider selling off assets once Bank Rate reaches 1%, thus adopting an even faster rate of balance sheet reduction. In my view, for what it is worth, this may prove unnecessary given the sharp pace of reduction generated by ceasing reinvestment. It may also significantly complicate the government’s efforts to finance the deficit. After all, if the BoE is selling gilts into a market which is saturated by primary issuance, the upshot is likely to be a sharp rise in bond yields.

Whilst there clearly are some risks associated with a policy of running down the balance sheet, the BoE believes that “the impact on monetary conditions of a reduction in the stock of purchased assets, when conducted in a gradual and predictable manner and when markets are functioning normally, is likely to be smaller than that of asset purchases on average over the past.” In other words, running down the balance sheet gradually is likely to have only a modest impact on the economy. However, it is generally accepted that central bank balance sheets will not fall back to pre-2008 levels any time soon. For one thing, there has been an increase in demand for central bank reserves by the banking sector due to changes in regulation and banks’ risk management techniques which has resulted in increased demand for high quality liquid assets. For this reason, it is unlikely that the BoE will follow a policy of full disinvestment over the medium-term.

The likes of the now-departed Andy Haldane expressed concern that the BoE’s balance sheet was too big. Therefore reducing it over the medium-term is likely to diminish the criticism that the BoE is somehow engaged in deficit financing – a point Governor Andrew Bailey was keen to refute during today’s press conference. Nonetheless, balance sheet management is a policy tool which is here to stay. With downward pressure on equilibrium interest rates, as a result of population and productivity trends, the scope for using conventional interest rate policy is diminished and balance sheets will therefore remain a useful addition to the policy armoury. But just as increasing balance sheets proved to be controversial, so the process of running them down will likely prove to be a lot more difficult than currently imagined, as the 2013 US taper tantrum illustrated.