The writer is head of macro research at BNP Paribas Asset Management
The Bank of England has invested hundreds of billions of pounds in the bond market over more than a decade since the financial crisis. The time has surely come to reflect on how this programme works and whether there is a better way.
The BoE clearly needed to respond when the UK economy went back into lockdown. The markets expected an expansion of the central bank’s asset purchase programme, known as quantitative easing, and they were not disappointed.
What is surprising though is the way that the BoE thinks that QE influences the economy and the way it conducts those asset purchases.
There are two schools of thought about how QE affects the economy and two schools of thought about how long the effect lasts.
Starting with how, most investors believe in an intuitive demand-versus-supply explanation of QE. In the process of buying bonds, central banks bid up the price, driving down bond yields.
This argument is controversial in academia, where it is sometimes argued that demand and supply do not determine yields — certainly not in the long run. Instead, it is argued that it is the signal implicit in a central bank’s decision to purchase assets that influences the bond market. That signal could be about the central bank’s assessment of the state of the economy or how it plans to respond to events in the future.
Turning to how long, the “stock theory” that is favoured by many economists argues that purchases which took place long ago under previous governors Mervyn King and Mark Carney are still influencing rates today. In contrast, the “flow theory” that is favoured by some investors argues that the size of the bond portfolio that the BoE has accumulated over the past decade is not relevant to current bond yields: only transactions move markets.
The BoE’s Monetary Policy Committee appears to believe simultaneously in the signalling explanation and the stock theory in setting a target for purchases. That is a puzzle on many levels. First, the committee must believe that the message that Lord King encrypted within the decisions to purchases bonds a decade ago is somehow still having an impact on yields.
Second, QE is an extraordinarily expensive and opaque way to send a signal. The BoE assumes that the market can correctly decode the message that is embedded within the decision to buy billions of bonds. If the committee has a signal to send then it should carefully calibrate the message and just say it.
But perhaps the biggest puzzle of all is why the BoE persists with its current approach given no one is quite sure how a given quantity of bond purchases influences bond yields — which is what the central bank ultimately cares about.
Fortunately, there is a simple solution known as yield curve control. The MPC should vote on the target level of bond yields that it believes is consistent with price stability and then adjust the quantity of bond purchases as necessary to deliver that target.
This is not a revolutionary idea. The Bank of Japan has been implementing yield curve control for years. The European Central Bank appears to have informally — but perhaps only temporarily — adopted yield curve control during the Covid-19 crisis.
At the start of the bond-buying experiment, it was reasonable to argue that QE could stimulate spending by reducing short to medium-term interest rates. But bond yields at those horizons have now been crushed down close to zero. And with little hope that spending is particularly sensitive to the limited further falls in long-term yields still possible, it is getting increasingly difficult to argue that additional QE can provide extra stimulus.
The reality is that it is now fiscal policy that is doing the heavy lifting to support the economy through the pandemic. Governments have been obliged to borrow huge sums.
QE can still play an important supporting role in these circumstances by absorbing the increase in bond issuance. Rather than pushing yields down to stimulate spending, the objective of QE is now to maximise the positive impact of government spending by preventing yields from rising in response.
Yield curve control is clearly preferable to conventional QE in the current circumstances. Investors may even stabilise interest rates around the yield target without the BoE actually having to intervene.
The alternative is the central bank feeling obliged to increase QE whenever the government signals more issuance is coming. That can feed the unfortunate narrative that the government is now calling the shots on bond purchases.
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