QE as far as the eye can see

As the British economy recovers, what will the Bank of England do with its monster portfolio of government bonds? Christopher Alkan reports

The British economy shows tantalising signs of returning to normality after the 2008 financial crisis. The same cannot be said of the Bank of England's balance sheet. More than five years after the sub-prime crisis rocked markets, the Old Lady of Threadneedle Street still owns around £375bn of government bonds – about five times more assets than it held at the start of 2007.

While this giant portfolio has stopped growing, the Bank still uses proceeds from maturing bonds to buy replacements. But as with other central banks that engaged in quantitative easing or QE, the Bank of England will ultimately face the question of how quickly to shrink this monster portfolio and by how much.  

Marc Chandler, Chief Currency Strategist at investment bank Brown Brothers Harriman, believes that the Bank of England's balance sheet will remain huge for many years to come – even as current bonds are repaid by the Government.

“The Bank will not want to start withdrawing monetary easing until it is sure that the economy can stand fully on its own feet,” he says. “Central bankers are eager to avoid a repeat of America's experience in 1937 when premature tightening from the Federal Reserve caused a double-dip recession in the US. So this will be a gradual process that is drawn out over years.”

There is also no particular need to rush to tighten at present, says Philip Shaw, Chief Economist at Investec in London. “The British economy is growing faster than at any time since 2007,” he says. “But there is no sign that inflation is a problem.” In February, retail prices climbed by just 1.7%, the slowest increase in four years. In addition, it was only in February that unemployment dipped below 7% – the level at which the Bank of England has said it would start contemplating raising rates.

There are other reasons to suspect that a scaling back of the Bank's asset portfolio won't happen anytime soon. “Bank of England Governor Mark Carney has said that he won't start selling assets at least until interest rates begin to rise – which we expect will occur only at the end of 2015,” says Paul Hollingsworth, an analyst at Capital Economics in London.

Going into the market and selling large volumes of assets would be extremely disruptive, economists warn. The Bank of England owns about 28% of outstanding British government debt – a massive share. “Given such huge holdings, outright sales would risk alarming the market and pushing interest rates sharply raising interest rates,” says Chandler. “The result would be heftier borrowing costs for individuals and businesses, hampering economic growth.”

At present, the Bank of England is wary even of taking the baby step of allowing its portfolio to shrink naturally as bonds mature. At the moment, the Bank is reinvesting any money from coupons or principal repayments back into gilts. Without this action, Shaw says, the balance sheet would have already have started contracting. “About $20 bn of gilts will mature in 2014 alone,” says Shaw. About $75 bn of the Bank's portfolio is due to be repaid by the end of 2017. “Of course it would take a very long time for the bank to dispose of all of its bonds through this process of attrition,” he observes. The Bank has £7.1 bn worth of bonds that only mature in 2060. It would be waiting until 2068 for another £94 m to be repaid. If the Bank wants to shrink its balance sheet back to around $75 bn just by allowing existing bonds to mature would take about 35 years, according to figures provided by Investec.

“The fact that the bank is still unwilling to take this baby step of letting the balance sheet shrink gradually shows that there is still a commitment to keeping the monetary policy setting expansionary,” Shaw says.

There is a good chance that the Bank's balance sheet may never shrink back fully to its pre-crisis size. In September 2011, David Miles, a member of the Bank's interest rate-setting Monetary Policy Committee, said the Bank would “probably operate permanently with a substantially larger balance sheet.” Banks have become accustomed to using larger balance sheets as a tool of monetary policy, says Chandler. “This used to be unorthodox monetary policy,” he says. “There is a good chance that it will become a standard tool.”

Predicting the course of monetary policy is notoriously difficult. But most economists agree it will be many years before the Bank of England even starts to allow its balance sheet to contract.

Published: 30 May 2014
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