Quantitative tightening

There are a variety of views about the desirability of the Bank of England undertaking quantitative tightening (QT), whether it has a good strategic framework for doing so, and whether it is conducting QT at an appropriate pace. Nonetheless, much of the evidence we have received suggests that the Bank’s strategic framework for QT is broadly reasonable. We have also heard that shrinking the Bank’s balance sheet in order to create space for future interventions, should they be needed, and reducing distortions in the gilt market caused by quantitative easing (QE), are potential reasons for going ahead with QT.

Since it has some bearing on our later conclusions, we note here that the Bank and Monetary Policy Committee (MPC) have determined: that QT is not being used as an active tool of monetary policy; that they are calibrating QT in order to minimise its economic and financial impacts; and that they are carrying out QT with a view to creating space for future balance sheet expansion, such as quantitative easing (QE), should it be needed. We also note that we have received some concern that the Bank needs a good understanding of the economic and financial impacts of QT in order to calibrate its strategy.

One area in which the Bank’s strategy is less well established regards the long-term steady-state size and composition of its balance sheet, which may have a bearing on the longer-term conduct of QT and which, as we note later, may have implications for fiscal as well as monetary and financial stability policy.

The Bank should develop its planning on this long-term steady-state size and composition of its balance sheet, and how this relates to QT, in more detail and give regular public updates on the likely future size and composition of its balance sheet. (Paragraph 23) The macroeconomic and financial impact of quantitative tightening

QT is a comparatively untested monetary policy tool, and it is understandable that the Bank would find it challenging to model its effects as part of its forecast. We have seen supporting evidence for the Bank’s contention that it is having and will have a small impact on the economy. That said, we are concerned that the Bank is taking a ‘leap in the dark’ by embarking upon a major monetary operation without specifically and separately tracking its effects. As we noted above, there is a spread of views about the appropriate pace of and risks around QT, including a risk that QT is tightening monetary conditions by more than the Bank thinks. The MPC’s ability to set the appropriate course of monetary policy could be improved if it has as full as possible an understanding of QT’s effects either at the pre-announced pace or in alternative scenarios.

The Bank should develop its forecasting and modelling tools for understanding the impact of QT and look to how these can be integrated into the forecasting and communication process. Given the uncertainty over its effects, the Bank should also Quantitative Tightening 35 update Parliament and the public on QT at each quarterly Monetary Policy Report, rather than at an annual review only. At these reviews, it could examine the impact of QT on the money supply and the consequences for growth and inflation.

There are no clear signs that QT has resulted in financial stability issues to date, either in the gilt market or more widely. We also recognise that bringing down the share of gilts owned by the Bank in favour of the private sector could improve liquidity in financial markets. Nonetheless, QT is an untested intervention in a gilt market that is also faced with an unusually high sustained rate of conventional gilt issuance, which could risk contributing to a financial instability event. The events of March 2020 and September 2022 have shown that the market can deteriorate rapidly.

The Bank is right to work on a new backstop facility to reduce the chance of having to resort to gilt purchases in future, and given that QT is ongoing, it should work on this as a priority. In the meantime, it should consider whether a fully developed and transparent contingency is needed should it have to go further and suspend QT and/ or resort to gilt purchases, as it had to on an improvised basis in September 2022.

Given the unusually high extent of gilt sales in the coming years, the Bank and the Debt Management Office should publish more frequent updates on gilt market participant demand and sentiment. (Paragraph 51) The fiscal impact of quantitative easing and tightening

Notwithstanding the need to ensure that the programmes are compatible with the operational independence of monetary policy, it strikes us as highly anomalous that decisions have been and are being taken about QE and QT concerning huge sums of public money without any regard to the usual value-for-money requirements. This may have been more easily tolerable had QE remained at the relatively modest scale originally envisaged, or had a lifetime loss remained an unlikely scenario rather than the central projection. As it is, with the benefit of hindsight there is no reason to think that the indemnity and cashflow arrangements devised in 2009 and 2012 are the most suitable available.

We recognise that QE and QT are processes already well in train, and it may not be possible to make large changes to the arrangements made in 2009 and 2012 without impacts on the credibility of the UK macroeconomic framework. However, as we have noted, the Bank is undertaking QT in part to create space should it need to undertake QE or another form of balance sheet expansion in future. Given what we now know, any future QE should not proceed automatically under the existing arrangements. Instead, the arrangements should be revisited in the light of the implications for value-for-money, public spending and Bank independence that we outline below.

While the Governor played down the impact that decisions over the pace of QT have on the scale of lifetime gains and losses arising from QE and QT, the evidence presented to us shows that there is some trade-off between the two, and more so 36 Quantitative Tightening in terms of annual losses. Furthermore, the Bank and MPC do not consider QT to be an active tool of monetary policy and think that it has minimal economic and financial impacts.

That being so, while it is right that MPC members should have monetary policy and the inflation target foremost in their thinking and decision-making, the Bank and Treasury should explore how criteria on value for money and the spending power of the Treasury could be included in decisions about the ongoing pace and timing of QT.

It is right to say that the overall effectiveness and value-for-money of QE and QT should be judged by their wider macroeconomic impacts on inflation, growth, and employment, rather than on the direct fiscal costs alone. There is agreement among many that certain rounds of QE, especially the initial rounds, were effective and easily justify the later fiscal cost. However, there is a spread of views about the relative economic impact of later rounds of QE, including, it seems, among Bank officials.

In its response to this report, the Bank should set out whether it thinks that all individual rounds of QE have proved to be good value for money considering the later fiscal cost. In any future QE, lessons should be learned about the effectiveness of each round of QE over 2009 to 2021 and how it might be used more selectively, partly with reference to the fiscal implications.

The Chancellor’s role in approving changes in the size or composition of the APF that houses the QE and QT programme remains unclear to us, since on one hand the Chancellor insists that decisions over QE and QT are taken independently by the MPC and cannot be commented upon, while on the other hand the Chancellor’s authorisation is “accompanied by assessment of the macro-economic and fiscal impacts.”

The Treasury should clarify whether the Chancellor’s authorisation of changes to the APF involves a substantial decision or is only a formal endorsement of the MPC’s decision, and explain the extent of the assessment of macro-economic and fiscal impacts that accompanies each authorisation. In particular, the Treasury should confirm whether or not there was a threshold at which the indemnity would not be provided.

We have received proposals for interventions that would cut the remuneration of bank reserves and thereby reduce the ongoing losses arising from QE and QT. However, we have also received evidence that cutting remuneration now could be similar to a default, and that any scheme tied to commercial banks’ holdings of reserves could undermine financial stability. Overall, we do not support cutting the renumeration of Bank reserves. We believe taxes on banks should be set through Parliament in a Finance Bill.

Some witnesses thought that the remuneration of reserves would need to be reconsidered once reserves had reached their future steady-state level. However, there is a lack of information about future arrangements for the Bank’s balance sheet once the steady-state level of reserves is reached. (Paragraph 82) Quantitative Tightening 37

The Bank and Treasury should clarify the future arrangements for the steady-state level of reserves on the Bank’s balance sheet as soon as possible, including the future of QT at that point, the assets that will be used to back reserves, the remuneration of those reserves, and the implications for the Bank’s profits and losses and the Treasury indemnity.

QE and QT losses, the fiscal rules, the regular remittances of profits arising from QE from the Bank to the Treasury and indemnity payments to cover losses from the Treasury to the Bank interact to create direct and immediate links between monetary policy decisions and fiscal policy. The current losses thereby have worrying implications for public spending, taxation and borrowing, and for the operational independence of monetary policy.

The Treasury should examine whether it is appropriate that ongoing indemnity payments are included in the debt targeted by the fiscal rules, subject to maintaining the credibility of the UK’s macroeconomic framework. For any future rounds of QT, the Treasury and Bank should commit to revisiting whether it would be possible and appropriate to account for profits and losses in a way analogous to the deferred or derivate asset approach being employed in the US and elsewhere. In particular, the 2012 decision to remit cashflows quarterly between the Bank and the Treasury should be reconsidered, should future QE generate profits. (Paragraph 92) 38 Quantitative Tightening