The grand committee of the House of Lords is due to debate the following motion on 15 November 2021:

Lord Forsyth of Drumlean to move that this House takes note of the report from the Economic Affairs Committee, Quantitative Easing: a Dangerous Addiction?

What is quantitative easing?

Quantitative easing (QE) is a form of monetary policy first used in the UK in March 2009. Internationally, it was first introduced by the Bank of Japan in 2001.

Prior to the financial crisis of 2007 to 2009, the main tool of monetary policy in the UK was the Bank of England’s ‘bank rate’. This is a key interest rate that influences other rates throughout the economy and hence also other economic variables. The Bank of England (the ‘Bank’) reduces the bank rate when it wishes to stimulate activity and prices. Conversely, it increases the rate when aiming to reduce activity and control inflation.

In March 2009, the Bank reduced the bank rate to 0.5%. At that level, the Bank considered there was limited scope for further reductions. However, given what it described as a “sharp and synchronised” global economic downturn, it still believed further economic stimulus was needed. Therefore, it introduced QE.

QE takes the form of the Bank buying government bonds, and to a lesser extent corporate bonds, from other financial institutions such as banks and pension funds. The Bank states that this “acts in a similar way” to cuts in the bank rate. For example, the Bank believes it increases the price of bonds, because there is more demand for them. This automatically reduces the interest rate, or ‘yield’, that holders of bonds receive, as the prices of bonds and their yields move inversely. These lower interest rates feed through to other rates throughout the economy.

In addition, buying bonds from financial institutions leaves those companies with additional cash. The Bank states that rather than holding on to cash, the beneficiaries will usually invest in other assets, such as shares. This increases the prices of those assets, making households and businesses wealthier and therefore promoting spending. Alternatively, the institutions might increase their lending to households and businesses, again boosting the economy.

Since 2009, the bank rate has remained below 1.0%. Most recently, it was reduced to 0.1% in March 2020 in response to the coronavirus pandemic.

How is it funded?

The organisation Positive Money, which campaigns for monetary reform, describes how the Bank funds QE by creating new supplies of central bank reserves. This is a type of money used only for transactions between private sector banks and the Bank of England. For example, if the Bank buys a bond from a pension fund, the pension fund might be paid by receiving a deposit at a high street bank. The high street bank would, in turn, receive an additional asset in its central bank reserves. The Bank of England pays interest on central bank reserves to private sector banks at the bank rate of interest. The effective cost of the money created through QE is therefore the bank rate.

In practice, the Bank’s QE operations are carried out through a public body established for the purpose, the Asset Purchase Facility (APF), which is a subsidiary of the Bank. The APF can make profits or losses because the interest and income it receives from bonds it has bought may exceed or fall short of the cost of its operations, which are (mostly) interest payments at bank rate on the stock of QE. However, the APF is fully indemnified by HM Treasury. Thus, the taxpayer ultimately bears the cost of any losses, as well as receiving the benefits of any profits.

How much QE has taken place?

The Bank reported that at the completion of the current round of QE it will have bought £895 billion of bonds. Of this total, £875 billion were government bonds and £20 billion corporate bonds. Approximately half of this took place prior to the coronavirus pandemic, and half since March 2020. The BBC has reported that, when the current QE is complete at the end of 2021, the Bank will own over a third of the total government debt. Similarly, the Economic Affairs Committee observed that the total size of the QE programme will be equivalent to around 40% of UK GDP.

QE is not unique to the UK. The US thinktank the Atlantic Council reported that, collectively, the four largest central banks in the world (the US Federal Reserve, the Bank of Japan, the European Central Bank and the Bank of England) have collectively purchased $24.5 trillion of bonds.

Decisions on QE and interest rates are made by the Bank’s Monetary Policy Committee (MPC). At its most recent meeting in November 2021, the committee voted by a majority of 6 to 3 to continue with its existing programme of bond purchases. This will take total QE to £895 billion by the end of 2021, as outlined above.

The Economic Affairs Committee report

Overall effects of QE

Summarising academic views on the effect of QE, the Economic Affairs Committee said that many professional economists, as well as the Bank itself, supported the view that QE was important in crisis conditions. In particular, the committee said QE was effective in stabilising financial markets when they would otherwise become “dysfunctional”.

However, the committee said that evidence on QE’s effects on the wider economy was “mixed”. For example, one witness told the committee that “its effectiveness as a tool to address stagnant or low rates of investment and growth appears to be negligible”. On the other hand, the Bank’s evidence stated that “studies of the effects of QE tend to find meaningful impacts on both GDP and inflation”. The committee concluded that QE’s impact on the real economy was “limited” and that, comparing its different sources of evidence, “central bank research tends to show quantitative easing in a more positive light than the academic literature”.

The committee found that the Bank’s understanding of QE had not increased in line with the expansion of the programme itself. This included knowledge of both the impact of QE and the means by which it affects the real economy (its ‘transmission channels’). The committee called for the Bank to improve its understanding of the policy’s effects on the economy over various time horizons and to prioritise research in this area.

On the scale of QE, the committee found that, although initially intended to be a short-term policy in response to the financial crisis, it has since been used to respond to a range of different problems. The committee said this has created a “ratchet effect, whereby the scale of quantitative easing has been increased repeatedly, with no subsequent attempts to reverse it”. It contended that, in practice, QE has “become the Bank of England’s main monetary policy tool”.

However, the committee argued the Bank has “struggled to explain why it was the appropriate response to particular economic circumstances”. On communications overall, it concluded that the level of detail published by the Bank on how QE affects the economy is insufficient to enable Parliament and the public to hold it to account. This, it says, has “bred mistrust”. It called on the Bank to be more open in its assessments of the appropriateness of QE; for example, setting out how it calculates the amount of asset purchases needed to achieve a stated objective, and publishing analysis of the extent to which each stage of QE has achieved its objectives.

Interaction with fiscal policy

The committee reported views that the expansion of QE during the coronavirus pandemic was motivated by enabling the UK government to continue to borrow, at low rates of interest, to finance its pandemic-related spending. For example, it reported a Financial Times survey which found that the “overwhelming majority” of the 18 largest investors in Government debt believed the Bank had bought gilts to keep the Government’s borrowing costs down.

The Bank’s explanation of QE accepts that lower government borrowing costs were a consequence of the policy. However, it said this is “not why we do QE”, which is to “keep inflation low and stable and support the economy” (as set out in more detail in the introductory section above).

The committee stated that, regardless of the reasons for QE during the pandemic, the “widespread perception” that government debt financing was a motivation could significantly affect the Bank’s ability to control inflation and maintain financial stability. It said that “poor” communications from the Bank could have contributed to this perception. Again, it argued this made it “imperative” that the Bank is held accountable and that it explains the reasons for its decisions openly and in sufficient detail.

QE has also resulted in the cost of servicing the government’s debt becoming much more sensitive to future interest rate increases. For example, the Government has said the fiscal impact of a one percentage point rise in interest rates would be “six times greater than it was just before the financial crisis, and almost twice what it was before the pandemic”. The committee argued that this led to risks that the Bank could come under political pressure not to raise interest rates when necessary to control inflation.

The committee considered possible measures to counteract the sensitivity of debt interest to changes in interest rates. For example, the Bank of England could stop paying interest on central bank reserves (see section on ‘How is it funded?’ above). However, the committee said this would “amount to fiscal policy as [it] would effectively be a tax on the banking sector”. It therefore argued that HM Treasury should state clearly that such decisions would be a matter for the Government and not the Bank.

QE and inflation

Traditional economic theory states that, in some circumstances, printing or creating money leads to inflation, although there may also be situations in which it does not. The Bank itself has stated that the effectiveness of QE varies depending on the state of the economy.

The committee found that the effect of the QE monetary expansion on inflation has been “unclear”. It concluded that the current round of QE may be more likely to be inflationary because it coincides with a period of “substantial Government spending, bottlenecks in supply, and a recovery in demand after the Covid-19 pandemic”. It noted indicators of increasing short-term inflation in the current UK economy. The committee also observed that a decision on when to tighten monetary policy could risk becoming politicised, because an increase in interest rates to control inflation could put at risk the Government’s policy to stimulate economic growth.

To combat this risk, and to provide for greater transparency, the committee recommended that the Bank should provide more information on its analysis, forecasts, and contingency plans in relation to QE.

QE and the net zero target

In March 2021, the Government updated the Bank’s mandate to include supporting the Government’s environmental policy, which is to achieve “strong, sustainable and balanced growth that is also environmentally sustainable and consistent with the transition to a net zero economy”.

The committee found that this change risked “politicising” the Bank and jeopardising its independence. It contended this was because the new mandate could require the Bank to choose which corporate bonds to purchase as part of its QE programme, rather than, as previously, being market-neutral. The committee argued this could also lead to certain sectors being favoured (such as renewable energy producers) or disfavoured (eg fossil fuel companies). Further, the committee argued that the risk of this politicisation was greater than necessary because the mandate provided by the Government on its environmental policy has been “ambiguous”. It called on HM Treasury to provide greater clarity on the interpretation of the objective.

Deed of indemnity

The committee heard from an academic witness, Dr Will Bateman, that the deed of indemnity between HM Treasury and the Bank’s APF “commits the UK’s taxpayers to potentially enormous liability”. The committee agreed that the deed required the taxpayer to pay any financial losses arising from QE. These would arise if the bank rate rose above the average rate of interest the APF received on its bond holdings. Given this taxpayer commitment, the committee said it was “extraordinary” that HM Treasury had refused to publish the deed, which is a contractual document between two public sector bodies, without explaining why.

Effects on inequality

The committee said that the effects of QE on inequality in the UK were “difficult to measure separately from other economic events”. It reported a range of evidence from its witnesses that reached different conclusions. It noted the Bank’s own analysis that suggested the impact of QE on inequality was “relatively small”. On balance, the committee found that QE is likely to have exacerbated wealth inequalities in the UK. It said this was because QE’s main effects act to increase the prices of assets, which primarily benefit wealthier households. The committee did not reach a conclusion on QE’s effects on income inequality. It called for the Bank to publish an “accessible” overview of QE’s distributional effects, which should outline the range of external views as well as the Bank’s own.

The committee stated that the effects of QE on wealth inequalities could only be mitigated through fiscal policy. It therefore also asked HM Treasury to comment on any Bank research on distributional impacts.

Unwinding QE

The committee considered the possible approaches if the Bank decides to “unwind” QE. These include selling bonds back to the market or allowing the bonds to mature and not replacing them. The committee noted the Bank has set out a framework for how it would approach this decision. However, the committee set out a series of risks to the process, such as market instability and a spike in inflation. It argued that unwinding might also give rise to risks to the Bank’s independence, because of the significance of its government debt holdings and possible conflicts with other economic priorities. The Bank is also reviewing in which order to unwind QE and raise interest rates.

The committee called for the Bank’s review to be concluded urgently and for it to set out a clear plan for unwinding QE and “restoring policy to sustainable levels”.

How did the Government and Bank of England respond?

The Bank and the Government published separate responses, addressing the recommendations that bear on their respective areas of responsibility.

Bank of England response

The Bank of England published its response on 16 September 2021. In view of the committee’s findings that QE risked politicising the Bank, the response reiterated the Bank’s independence and said several safeguards had been put in place to preserve it. These include new arrangements set up alongside the APF, such as assurances that QE should not directly affect gilt issuance to fund the government’s deficit.

Regarding the committee’s allegation of a “widespread perception” that QE has been aimed at financing the government deficit, the Bank said this was “unsubstantiated”. The Bank stated that if this had been the case, inflation expectations and gilt yields would have risen. In contrast, the Bank stated that “indicators of medium-term expectations of future inflation have remained well anchored”.

Other elements of the Bank’s response included that:

  • It had set out in detail its strategy for tightening monetary policy and unwinding QE in its August 2021 Monetary Policy Report. For example, the Bank said it intended to begin to reverse QE when the bank rate reached 0.5%, “if appropriate given the economic circumstances”. However, it restated its view that immediate action was not necessary as the current drivers of higher inflation were transitory.
  • It was continuing to enhance its understanding of QE, including through specific “priority topics” on its research agenda. However, it added that the Bank’s interpretation of the existing literature on QE suggested that it had had a stronger impact on growth and inflation over the past decade than the committee’s report suggested.
  • The Bank was working to develop new and accessible ways of explaining its monetary policy tools.
  • Studies on the distributional impacts of QE have shown “mixed” results. The bank’s own research suggests “the impact of monetary policy on wealth and income inequality to have been limited”. For example, it said the numerical measures of inequality (‘Gini coefficients’) have remained broadly unchanged: over the last two decades for income inequality and over the last decade for wealth inequality.

On 5 November 2021, the Bank published details of how it will “green” its corporate bond purchasing scheme. It said that firms would need to satisfy climate-related eligibility criteria for their bonds to be purchased. The Bank stated the new approach would lead to a 25% reduction in the weighted average carbon intensity of its corporate bond portfolio by 2025, and full alignment with net zero by 2050.

Government response

The Government also published its response on 16 September 2021. Noting that the committee’s report raised complex and wide-ranging issues in relation to QE, it stated that:

  • The Government “noted” the recommendations that HM Treasury should do more to understand the effects of QE and also to acknowledge that its impact on inflation and output is uncertain, but did not commit to specific actions in this area.
  • On the committee’s call for further evidence on the impact of QE on inequality, and whether the Government should consider using fiscal policy to mitigate any such impact, the Government’s response stated it considers all evidence, including the Bank’s research, when making policy. The Government response added that all monetary policy has distributional effects.
  • On the Bank of England’s mandate to support the Government’s net zero policy, HM Treasury believes it is for the MPC to interpret this in light of its primary objective of price stability.
  • On debt management, and specifically the suggestion that the Bank of England could stop paying interest on central bank reserves, the Government said it “is not considering” such a policy.
  • The Government had “carefully considered” the decision not to publish the deed of indemnity. In later oral evidence to the committee, on 2 November 2021, the Chancellor of the Exchequer, Rishi Sunak, said that the reason for not publishing the deed of indemnity was that it has “operational sensitivity”, adding that there was “a balance between transparency and making sure that we do not compromise the need to execute various things effectively”.

Bank of England’s independent evaluation office report

In January 2021, the Bank’s own independent evaluation office produced a report on the Bank’s implementation of QE. Its findings included that the Bank:

  • had implemented the programme effectively, with strong governance processes and robust infrastructure;
  • had “honed its communications” on what is a “complex tool”; and
  • has learned and adapted as QE progressed.

The report recommended the Bank should:

  • continue to improve its technical understanding of QE;
  • review its governance arrangements and invest further in risk management infrastructure; and
  • develop more strategic and more accessible, “layered” communications to address different target audiences.

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Cover image by Adrian Pingstone on Wikimedia.