Quantitative Disorders | FinancialTimes

On both sides of the Atlantic, central bankers face the unenviable task of raising rates until a possible recession. The higher rates rise, the greater the risk that the Federal Reserve and Bank of England will control inflation at the expense of jobs.

There is, however, a (partial) solution: to use their bloated balance sheets – bloated by the financial crisis and the fight against pandemic crises as an alternative to abrupt increases in interest rates.

After all, quantitative easing was used to stimulate economic conditions after the financial crisis and the pandemic. So why not actively use the balance sheet now as a way to tighten things up? This could result in price stability with lower short-term rates than would otherwise be the case.

Interestingly, that seems to be what the Fed is doing, while the BoE seems to reject the idea. Why?

As a central disclaimer, no one really agrees on how QE works, let alone its creepy sibling “quantitative tightening.” But it seems at least theoretically possible that central banks could use QT to do some cooling through reverse “wealth effects” as well.

Although no central bank has enough evidence to describe the likelihood of this sequence of events, the Fed has been quick to articulate a role for its balance sheet in bringing price pressures down to earth. Take this statement from Fed Vice Chairman Lael Brainard in April:

The reduction in the balance sheet will contribute to the tightening of monetary policy beyond the planned increases in the policy rate reflected in market prices and in the Committee’s summary of economic projections. I expect the combined effect of rate hikes and balance sheet shrinking to take policy to a more neutral stance later this year, with the extent of further tightening over time depending on how inflation and employment outlook.

No one from the BoE said anything similar, instead officials delivered a series of confusing and somewhat contradictory statements about how the balance sheet fits into its overall monetary policy strategy.

Deutsche Bank economist Sanjay Raja told FT Alphaville that the BoE had done all it could to minimize the impact of its own fledgling version of QT. His August 2021 Monetary Policy Report explicitly stated that if the intent of QE was to impact market expectations for rate trajectories (a reminder of the long-lost world of “lower for longer”), QT would not have the opposite effect:

First, the increase in the target stock of purchased assets may have provided a signal about the MPC’s aim to ease the overall policy stance in the past, depressing the expected path of the discount rate. In contrast, the MPC would not intend to use its decisions regarding the process of reducing the stock of purchased assets to signal the need for a higher path for the discount rate.

According to Raja, this was an effort to “remove much of the clamping element” that accompanies a possible unwind. Why is the Fed so much more prone to inflating the balance sheet as a policy tool than the BoE?

One reason could be the totally different maturity profile of their balance sheets. The Fed’s portfolio is fluid enough to allow a “run off” on different bandwidths depending on the pace at which it wishes to tighten. The BoE does not have this option.

According to FTAV calculations, about 20% of Treasury bills on the Fed’s books will mature next year and 58% within the next five. This gives it enough room to adjust the extent to which it withdraws liquidity from the market. Over the same time horizons, only 29% of the BoE’s gilts should come off its books.

This means that the only way for balance sheet contraction to be an active policy tool for the BoE is to oversell bonds. This process should be explicitly designed, rather than simply adjusting the pace of an already planned reduction.

The complexity of designing such a program may at least partly explain why the BoE is lagging behind the Fed according to James Smith, an economist at ING:

When the BoE presented its plan for QT in August 2021, it made it clear that active sales would be taken into account when they reached a discount rate of 1%. There’s no way that at that time the bank expected to get there in less than a year. In short, they may just need time to work on the operational aspects of the sale.

This interpretation certainly fits with the actions of the MPC last Thursday: instructing bank staff to leave and come up with a plan to sell the gilts.

The relatively convincing technical explanations of central bank behavior should not be overlooked. But it would be remiss of us not to point out an infinitely more interesting alternative argument that attributes different levels of QT hesitancy to something else – different levels of confidence in what it’s actually going to do.

The Fed has been here before. Some economists therefore believe that Powell and co may have just enough experience to judge how much reduced liquidity markets can handle without getting into trouble. The BoE, on the other hand, has no experience with QT. This makes the risk-reward profile of its own grand outcome more uncertain.

Jo Michell, professor of economics at UWE Bristol, pointed the FTAV to the hard truth that the Bank “cannot tolerate” the collapse of financial markets via a botched effort at QT. On the other hand, it can blame the Treasury for any rise in unemployment triggered by a rate hike.

As interest rates rise, there is no reason not to provide fiscal support to households, Michell pointed out. But would Rishi Sunak be willing to step in here and offer further assistance? We are dubious.

Given the uncertainty over how markets would react to the full sell-off – and the BoE’s mandate to protect both prices and financial stability – perhaps QT’s hesitation is the right move.

Our best guess, however, is that if there is no government help, ignoring the usefulness of balance sheet reduction as a way to help control inflation could end badly for the BoE.

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