Last week the Treasury Select Committee released its report on the Bank of England version of Quantitative Tightening (QT). My friend Chris Marsh and I contributed written evidence to the committee and I’m pleased that our work was referred to extensively in the final report. A major focus of the report was the apparent wilful gamble by the BoE in the design of its QT policy, particularly ‘the decision to actively sell gilts back to the market’. ‘Active QT’ is unusual among central banks. The BoE QT is especially noteworthy because losses indemnified by the Treasury be made good on a quarterly basis by direct fiscal transfers. The combination means ‘active QT’ as practiced by the BoE front-loads the fiscal impact, with obvious political implications. It does not have to be this way.
The Indemnification provided by Treasury in 2009 appears to have reflected concerns by then-governor Mervyn King that QE would undermine confidence in the BoE. Once signed the Bank has been reluctant to reassess the costly commitment. There are even better examples of managing such an indemnity. The Bank of Canada and Reserve Bank of New Zealand both agreed indemnities with their governments. Crucially, both the Canadian and the New Zealand agreements contain key differences to the BoE; QE assets would run off by maturity (‘passive QT’) and any unrealised losses would be accounted for by a book entry in derivative form. The combination minimises cash transfer from the fiscal authority while emphasising long-term commitment of the government to the central bank.
In contrast, the BoE approach adds to bond absorption difficulties, increases cash payment out of government coffers and adds political economy difficulties that could be avoided. At a time of fiscal stress across the developed world, these are not trivial concerns.
They may serve, however, to illustrate again how ad hoc central bank policy entraps monetary authorities into nervous commitment to an unstable status quo. Why else would senior Bank of England staff fail to re-consider agreements made in haste 15 years ago considering better arrangements are in place elsewhere?
There are real life consequences. We may ask whether the choice of QT approach by the BoE contributed to the Gilt market spasm in September 2022, one month before ‘active QT’ was initiated. We might also note that the idiosyncratic BoE approach to QT may have added 0.6% to average Gilt yields since mid-2022, adding further costs to the Indemnity as well as adding to government financing costs.
It is fear that stems from their lack of confidence in the rickety framework they have created. It may be well-founded. But a framework that confuses fiscal and monetary policy and adds to costs of both also undermines confidence in both. It is a fear that carries considerably more negative consequences in light of the inability of the Bank of England to achieve its primary inflation target. Confidence in the monetary authority has already eroded. Better now to find the most effective means of progress from here. Stirring up fiscal problems as an alternative to acknowledging previous ill-conceived policy will not improve the public standing of the Bank of England.
References:
The Reserve Bank of New Zealand Indemnity booked as a derivative
The indemnity from the Crown is accounted for as a derivative under PBE IFRS 9 as it contains contractual obligations and rights in regard to the transfer of cash at a future date, and consequently meets the definition of a financial instrument. The indemnity is accounted for at its fair value. The fair value of the indemnity is determined to be the direct inverse of the unrealised change in the fair value of the underlying assets less the funding costs of purchasing the LSAP securities. We also record as a liability or asset, as the case may be, unsettled payments to (or from) the Crown for realised net returns.
The Bank of Canada Indemnity booked as a derivative
Derivatives – Indemnity agreements with the Government of Canada were entered into to address market fluctuations resulting from the Bank’s operations under the Government of Canada Bond Purchase Program, Provincial Bond Purchase Program, and Corporate Bond Purchase Program. Losses resulting from the sale of assets within these programs will be indemnified by the Government of Canada, whereas gains will be remitted. These gains and losses are calculated as the difference between the fair value of these instruments and their amortized cost.