Quantitative Easing

While the UK can be proud of the economic credibility of the Bank of England, this credibility rests on the strength of the Bank’s reputation for operational independence from political decision-making in the pursuit of price stability. This reputation is fragile, and it will be difficult to regain if lost. So far, the Bank—and indeed other central banks which have used quantitative easing—have retained the confidence of international markets.

Quantitative easing is particularly effective as a tool to stabilise financial markets. There is strong evidence that shows it is an effective monetary policy tool when it is deployed at times of crisis, when financial markets are dysfunctional or in distress.

While the evidence on quantitative easing’s economic impact is mixed, we note that central bank research tends to show quantitative easing in a more positive light than the academic literature. We conclude, on balance, that the evidence shows quantitative easing has had limited impact on growth and aggregate demand over the last decade. To stimulate economic growth and aggregate demand, quantitative easing is reliant on a series of transmission mechanisms that operate primarily in and through financial markets. There is limited evidence to suggest that these increase bank lending or investment, or boost consumer spending by wealthy asset holders.

The Bank of England’s understanding of quantitative easing’s effects and its transmission mechanisms are far from complete more than a decade on from the policy’s introduction. Given that quantitative easing has increasingly become a conventional monetary policy tool, we recommend that the Bank of England prioritises research on: (Paragraph 55) the effectiveness of quantitative easing’s transmission mechanisms into the real economy; the effect of quantitative easing on inflation and how it helps the Bank of England to meet its inflation target; and the impact that quantitative easing has had on economic growth and employment.

Quantitative easing is an imperfect policy tool. Its use in 2009, in conjunction with expansionary fiscal policy, prevented a recurrence of the Great Depression and in so doing mitigated the growth of inequalities that evidence shows are exacerbated and deepened during economic downturns.

However, the mechanisms through which quantitative easing effectively stabilised the financial system following the global financial crisis have benefited wealthy asset holders disproportionately by artificially inflating asset prices. On balance, we conclude that the evidence shows that quantitative easing has exacerbated wealth inequalities.

The Bank has not adequately engaged with debate about the trade-offs created by sustained quantitative easing. We heard that it has been “defensive” about the extent to which quantitative easing has exacerbated inequalities. The Bank should publish an accessible overview of the distributional effects of quantitative easing which includes a clear outline of the range of views as well as the Bank’s view.

The extent to which, and how, quantitative easing interacts with fiscal policy is still poorly understood. What is clear is that quantitative easing has distributional outcomes that exacerbate wealth inequalities that can be mitigated only through fiscal policy. We do not believe this is a reason for the Bank of England not to use quantitative easing as a monetary policy tool. Rather, more effective countervailing policies can be introduced by Government if these negative distributional effects are better understood. We therefore invite HM Treasury to reply to any research that the Bank produces on the distributional effects of quantitative easing.

There is a widespread perception, including among large institutional investors in Government debt, that financing the Government’s deficit spending was a significant reason for quantitative easing during the COVID-19 pandemic. By its nature, quantitative easing lowers the cost of Government borrowing; this makes it difficult to disentangle monetary policy and deficit financing.

Perceptions that the Bank of England had acted primarily to finance the Government’s deficit were entrenched because the Bank of England’s gilt purchases aligned closely with the speed of issuance by HM Treasury. Furthermore, statements made by the Governor in May and June 2020 on how quantitative easing helped the Government to borrow lacked clarity and were likely to have added to the perception that recent rounds of asset purchases were at least partially motivated to finance the Government’s fiscal policy. If this perception continues to spread, the Bank of England’s ability to control inflation and maintain financial stability could be undermined significantly.

The level of detail published by the Bank of England on how quantitative easing will affect the economy is not sufficient to enable Parliament and the public to hold it to account. This has bred distrust. The Bank of England should be more open about its “assessment processes” for calculating the amount of asset purchases needed to achieve a stated objective. In its public communications, including Monetary Policy Committee minutes, the Bank should publish its assumptions, along with its assessment processes and analyse the breakdown the effect of quantitative easing at each stage of the programme and examine the extent to which it has achieved the Bank of England’s stated targets. We recognise that the quality of data on the effects of quantitative easing is limited but we believe that greater transparency will lead to improvements over time.

Any changes to the Bank of England’s mandate must be considered carefully. HM Treasury has updated the mandate to reflect environmental sustainability and the transition to net zero. These are important issues, but HM Treasury’s instruction is ambiguous, and its interpretation has been left to the discretion of the Bank of England. Without some clarification from the Government, the Bank risks being forced into the political arena, exposing it to criticism unnecessarily. The Chancellor should write to the Governor to clarify the Government’s expectations.

Quantitative easing’s precise effect on inflation is unclear, and the magnitude of recent quantitative easing on future inflation has not yet been established. However, we heard that the latest round of quantitative easing could have an inflationary effect as it coincides with substantial Government spending, bottlenecks in supply, and a recovery in demand after the COVID-19 pandemic.

There is a debate about the extent to which renewed inflationary pressures will be sustained over the medium to long term. We heard that the Bank’s response to sustained inflationary pressures will be a test of its independence. While the evidence is mixed, there appear to be short-term price rises across a series of indicators. Central banks in advanced economies appear to see the risks of inflation in terms of a transitory, rather than a more long-lasting, problem. We recommend that the Bank of England clarify what it means by “transitory” inflation, share its analyses, and demonstrates that it has a plan to keep inflation in check if its forecasts prove to be incorrect.

The growth of quantitative easing has increased the sensitivity of debt interest spending to changes in short-term interest rates. We are concerned that if inflation rises, the Bank may come under political pressure to not raise interest rates to control inflation because the risk to the public finances and debt sustainability would have increased significantly.

Managing the UK’s increased public debt accrued in response to the COVID-19 pandemic will require greater coordination between monetary and fiscal authorities. We heard a range of proposals setting out how the Bank of England and HM Treasury could mitigate the impact that interest rate rises could pose to the sustainability of the Government’s debt. These proposals amount to fiscal policy as they would effectively be a tax on the banking sector—we heard that if Bank Rate was to rise to 1% without interest paid on reserves, commercial banks would forgo around £9 billion a year based on current reserve levels. HM Treasury needs to clarify and put beyond doubt whether any decision to cease paying interest on reserves would be taken by Ministers, not the Bank of England.

The asset purchase facility is indemnified by HM Treasury, but the Deed of Indemnity has not been published. This is a contractual document between two public institutions. We heard no convincing explanation for why the document has not been placed in the public domain, which has concealed it from parliamentary and public scrutiny. The Chancellor has repeatedly ignored our requests for an explanation on why the document has not been published. HM Treasury should publish the Deed of Indemnity.

There is an increasing risk that central banks are facing a “no-exit paradigm” from quantitative easing. No central bank has managed successfully to reverse its asset purchases over the medium to long-term, and the key issue facing central banks as they look to halt or reverse quantitative easing is whether it will trigger panic in financial markets that spills over into the real economy.

It is not clear whether the Bank of England intends to raise interest rates or unwind quantitative easing first when policy is tightened. The Governor told us that the Bank of England is reviewing the order in which it intends to tighten policy but would not commit to publishing a roadmap. The rationale for reversing the order in which policy is tightened is yet to be fully explained, and we are concerned that the Bank does not appear to have a clear plan for tightening policy. This is concerning considering the renewed debate about inflationary pressures.

The Bank of England needs to set out a short-term plan for restoring policy to sustainable levels. We recommend that it expedites the review as a matter of urgency. As part of the review, the Bank should outline a roadmap which demonstrates how it intends to unwind quantitative easing in different economic scenarios.

When quantitative easing was introduced it was envisaged that it would support the UK economy after a sharp fall in aggregate demand following the 2008–09 global financial crisis. However, over the last decade it has been deployed in various circumstances quite different from those of 2009 to tackle a range of different problems. This has had a ratchet effect, whereby the scale of quantitative easing has been increased repeatedly, with no subsequent attempts to reverse it. This has only served to exacerbate the challenges involved in unwinding the policy. The Bank insists that quantitative easing has been an essential response to extraordinary and fast-moving events and always in line with its price stability mandate. However, the effects of quantitative easing remain poorly understood and in recent years, particularly during the COVID-19 pandemic, the Bank has struggled to explain why it was the appropriate response to particular economic circumstances.

Trade-offs that may have been acceptable in a policy designed as a temporary measure have become increasingly controversial as the programme has persisted. While the scale of quantitative easing has increased substantially over the last decade, there has not been a corresponding increase in the Bank of England’s understanding of the policy’s effects on the economy in the short, medium and long term. While we recognise that quantitative easing has prevented economic crises from spiralling downwards, its effect on inflation and output is uncertain, and it may also have increased wealth inequality by raising the price of certain assets, benefitting those who own them. The Bank of England and HM Treasury must do more to acknowledge this uncertainty and to understand these effects.

Quantitative easing has also made Bank of England and HM Treasury policymaking more interdependent, blurring monetary and fiscal policy, and this has started to erode the perception that the Bank has acted wholly independently of political considerations. We are concerned that scepticism of the Bank’s stated reasons for quantitative easing grew significantly during the COVID-19 pandemic, when many market participants said that they believed the Bank of England had used quantitative easing primarily to finance the Government’s deficit spending. If such sentiments continue to spread, the effectiveness of the Bank’s policies will be threatened severely. A reappraisal of how the Bank communicates its reasons for quantitative easing is needed urgently, as is the need for the Bank to provide a way for the public and Parliament to judge the success of the programme to ensure that it can be held properly to account for its decisions.

Finally, we are concerned that the scale of quantitative easing exposes the Bank of England to political pressure not to raise interest rates if rising inflation does not prove to be short-term as is forecast by the Bank. The Bank must define more clearly what it means when it states that rising inflation will be “transitory”; and it must explain in more detail why it is appropriate to continue with previously announced asset purchases when the economy is growing and inflation is rising at a faster rate than the Bank expected. The design of the quantitative easing programme and the size of the Bank’s balance sheet—now equivalent to 40% of GDP—has increased the sensitivity of the public finances to a substantial rise in debt servicing costs if the Bank needed to raise interest rates to control inflation. This will test the Bank’s independence. If it does not respond to the inflation threat early enough, it may be substantially more difficult for the Bank to curb it later. Failure to pass this test would damage hard won trust in the Bank of England’s ability to achieve its mandate.

We sympathise with the Bank of England that it has had to meet its mandate in an economic environment in which its independence has been more difficult to define compared to when operational independence was granted in 1997. Dealing with the economic consequences of the COVID-19 pandemic means the Bank necessarily working more closely with HM Treasury to ensure policy is complementary. However, HM Treasury has not helped to clarify its relationship with the Bank in its ambiguous answers to us. Furthermore, adding additional roles to the Bank risks it losing focus on its primary responsibility to control inflation.