BOE Has a Powerful Tool to Tighten Policy Without Raising Alarm
Inaction could be a powerful option for Bank of England officials looking to scale back stimulus for the economy and shrink their swollen balance sheet.
In a surprise move, Governor Andrew Bailey last week indicated that a “modest tightening” for monetary policy is likely in the next few years. When the time comes, it will begin with halting reinvestment of cash that comes from maturing investments in the BOE’s asset purchase facility.
The remarks give an indication how the BOE will start to unwind almost 900 billion pounds ($1.2 trillion) of government bonds it bought during the past decade. If the new policy kicks in around 2023, when investors anticipate, it could draw 400 billion pounds out of markets by 2030, based on BOE data detailing its gilt holdings through Aug. 4. Allowing gilts to mature would represent a gentle way to scale back support that the BOE lavished on markets help borrowing costs and maintain confidence among investors.
“There is a world of difference between ceasing to reinvest maturing holdings, and actively selling gilts,” said Aaron Rock, an investment director at Aberdeen Standard Investments. He likened the former process to “taking the foot off the accelerator” rather than applying the brake.
The Asset Purchase Facility has been the BOE’s main tool to boost the economy since the global financial crisis started more than a decade ago. Since then, policy makers injected more support in the form of bond purchases, or quantitative easing, around the time of Britain’s decision to leave the European Union and then again in the past two years during the coronavirus pandemic.
With the economy recovering sharply from its worst recession in three centuries, policy makers are now starting to talk about reining that support. Since no new doses of QE are planned beyond the end of this year, speculation is turning toward when the BOE reduces the scale of the holdings it built up.
Last week, officials said they’d halt reinvestments only once its benchmark lending rate, which is now at a record low of 0.1%, rises to 0.5%. Direct sales of gilts would happen only when the key rate hits 1%.
At the moment, when gilts in the asset purchase facility mature, the BOE reinvests that money in new securities to maintain the scale of its fund. Bailey said putting a stop to that policy would give investors predictability about the pace of tightening.
Crucially, it will save the market from an unpleasant surprise, with each stage of tightening dependent on the timetabled maturing of different gilts held by the Bank of England’s Asset Purchase Facility. If the move was announced at the start of 2023, it would take until July for the first bond to expire.
Money markets are betting the BOE will raise interest rates 15 basis points by June, with a further 25-basis-point increase to follow in early 2023. That would take the Bank Rate to 0.5%.
Lawmakers in Parliament added urgency to scaling back the BOE’s balance sheet. A cross-party panel in the House of Lords called for the central bank to justify the use of quantitative easing, saying it was adding to pressure on the public finances and inflating asset prices across the economy.
Even if it only halted reinvestments, the BOE would need to move carefully to avoid roiling the market given the unevenness of the dates when gilts come due, said George Buckley, U.K. economist at Nomura International Plc.
“It’s not like the Federal Reserve, where they have such a big portfolio and there’s so many Treasuries being issued all the time with redemption dates that vary quite a lot,” said Buckley. “It’s very patchy.”
For example, in 2024, when about 50 billion pounds of holdings mature, based on data on gilt holdings through Aug. 4. That includes:
- 2.9 billion pounds of bonds expiring in January
- 20 billion pounds in April
- 26 billion pounds in September
- In 2025, 82 billion pounds come due across four redemptions periods in January, March, June and September
There’s a possibility of significant market reaction around “potential tipping points,” in the BOE’s program, especially as the key rate approaches the 0.5% threshold for initiating the first stage of unwinding, said John Wraith, head of U.K. and European rates strategy at UBS Group AG.
“The market really needs time to get its head around it and sort of gradually adjust to pricing in that new information,” Wraith said.
Buckley said the BOE could end up delaying the decision to raise rates to that critical 0.5% level to ensure the economy is prepared to withstand the double whammy of quantitative tightening and a rate hike.
Scaling back the assets built up is likely to be a drawn-out process, lasting for years to give markets and investors time to adjust to the new stance. Bailey indicated that the overall scale of the BOE’s balance sheet is likely to remain hefty.
“We don’t know when we will hit that steady state, but we do know it will be a lot higher than it was before QE started,” Governor Andrew Bailey told Bloomberg News in a television interview last week.
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