Following the February MPC minutes and the clear signal from the ECB that it will probably raise rates next month, the monetary policy debate in the UK has shifted firmly to the pace with which policy should be tightened. While May still looks like the crucial month, however, the focus of that debate exposes something rather interesting about the Bank of England’s actions during the recession.
In particular, BoE watchers – and the Old Lady herself – are all currently obsessing on the timing of the first interest rate hike. Andrew Sentance wants 50bps now, Weale and Dale fancy 25bps, and the rest of the Committee want to leave Bank Rate at just 0.5%. Only Adam Posen is talking about quantitative easing, continuing to vote for a further Â£50bn of purchases in February.
This is quite revealing. Back at the end of 2008, when the BoE woke up to the recession and started cutting interest rates aggressively in an effort to catch up, it soon became clear that interest rate cuts, by themselves, would probably not be enough to support the economy. And that’s why the BoE pushed hard for alternative policy instruments, and in particular the Asset Purchase Facility (APF). After the APF was established in January 2009, it spent a few weeks engaged in credit easing before the BoE took rates as low as it wanted to and turned to Quantitative Easing (QE) instead.
At the start of QE, the Bank was at pains to point out that this was just an extension of normal monetary policy when rates got too low. Both Charlie Bean and Spencer Dale noted that the process of buying securities and thereby influencing market yields and asset prices was basically pretty much the same as under ordinary interest rate changes – this so-called ‘portfolio effect’ channel worked just as it did when rates changed. And, despite some scepticism from City economists, MPC members continued to champion the positive impact that QE was having on demand and spending, even if they couldn’t make up their minds exactly what the appropriate success criteria for gauging this were. Even last year the BoE published research suggesting the impact of QE could have been as much as lowering longer-term market yields by 1% (although personally I find Working Paper No. 393 more than a little dubious). Quantitative easing worked, Dale in particular repeatedly said (and still does).
So here’s an interesting question, at least to me as a nerdy economist. There is no reason that the BoE has to tighten monetary policy in the first instance by raising Bank Rate. Instead, the Old Lady could sell off some of the Â£200bn of assets that she bought during the recession. If QE worked so well and was so effective on the way in, surely quantitative tightening (QT) should be just as effective on the way out?
There would be procedural issues associated with this, of course. The Bank wouldn’t sell all Â£200bn in one slug, but would probably opt for sales of around Â£25bn (or multiples thereof) at a time, spread over several weeks. This would take a bit of organising – but so did the asset purchase auctions on the way in. Provided the MPC made a clear commitment to sell a fixed amount – and there is no reason they would not, just as they did on the purchasing side – the impact on forward-looking financial markets should be immediate, rather than as the sales happen. In fact, all of the theory and practice that applied on the way in with QE should still apply during QT on the way out, albeit often in reverse. And given that QE evidently worked so well in supporting the economy – and we know this because the MPC says so – QT should be equally effective in removing the monetary stimulus.
And yet, despite this, the MPC don’t talk about it as an option. Governor King was asked about QT at the press conference for the February Inflation Report and gave little away. In private I understand that MPC members acknowledge a desire to reduce the stock of asset purchases – but they are nervous about doing so at a time when the fiscal cuts are really about to bite, and favour waiting until the recovery is more firmly entrenched. People understand interest rates better, the logic goes – partly because the immediate impact is likely to be clearer in terms of households’ mortgage rates.
I agree with this view. But the very fact that when to raise rates is the prevailing discussion on the MPC tells us something about QE (and QT). A well known result in economics is revealed preference, which essentially says that people’s actions tell us what they really care about and believe, rather than their words. If the MPC are nervous about the precise impact and interpretation of QT, including the communication angle, that means that QT is not exactly equivalent to raising rates, in policy terms. And if the potential impact of QT is uncertain and unclear, relative to changing rates, so was (is!) the impact of QE. Admittedly the MPC was learning on the job when it started buying government bonds, and that experience may well have informed its current preference for rate rises (rather than QT). But a clear lesson here is that they should have been far more measured when talking about the economic impact of QE, acknowledging the uncertainty and doubts, rather than confidently and loudly proclaiming its success. With hindsight, some of those confident statements now look rather daft indeed.
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