What the BoE should do next
16 March 2010
Last Friday, I went to a conference attended primarily by leading academics from across the UK to consider the steps central banks can take once policy rates hit zero. It also examined how successful the various non-standard measures employed by the major central banks have been so far.
The consensus among participants was that the key policy tool for a central bank when faced with a zero interest rate was to provide cash in exchange for less liquid assets. Speaking at the conference, BoE Chief Economist Dale argued that this was exactly what the MPC was doing, exchanging cash for gilts. However, many academics thought that, as gilts are a reasonably close substitute for cash, the form of quantitative easing practised by the BoE has not been as successful as that of the Fed, which has mainly bought mortgage-backed securities (MBS).
The conference also discussed alternative policy options for central banks if the action taken to date proves insufficient. And, given that economic recovery in the UK is far from assured, the discussion focused on what the BoE could or should do. Participants identified three broad policy options:
- First, the BoE could increase its gilt purchases.
- Second, the BoE could widen its QE to buy private securities as well. The MPC already has permission to buy £50bn of private assets, funded by T-bill issuance. Alternatively, it could ask the Treasury to increase the limit on purchases funded by central bank reserves from £200bn, and spend the extra funds on asset-backed securities (ABS) and/or corporate paper. These assets are much less liquid than gilts and, if the academics are right, should therefore prove a more potent form of QE. And, as the BoE is indemnified by the Treasury against any losses, its balance sheet would not be at risk.
- Third, if the BoE is worried about outright purchases of private securities, it could opt for long-term open market operations instead. The BoE has expanded its long-term OMOs since the start of the crisis. But the list of eligible collateral is still heavily geared towards triple-A securities. Instead, the BoE could offer 12-month tenders against lower rated collateral (say, single-A). In this way, the BoE would let banks swap illiquid assets – including securities backed by new business lending and mortgages – for cash over long periods at a time.
- Finally, there is an obvious fourth option, which was not discussed at the conference – direct deficit financing. The BoE could decide that it needs a more direct route to get money into the economy. The most obvious way would be to use the Treasury as its agent to spend the new money it is creating. It could give (say) 5% of GDP in newly created money to the government for it to spend or pass on as a tax cut. This option has the advantage of ensuring that newly created money reaches the real economy quickly. But, although it has previously been discussed as a viable policy option by Fed Chairman Bernanke, such a money-financed tax cut would be anathema to an ultra-conservative central banker such as Mervyn King. Furthermore, outright central bank purchases of government debt are technically prohibited under the Lisbon treaty – so this hurdle would have to be overcome as well.
For now, the BoE is on hold. But if the recovery does stumble, there would be a strong case for the MPC to look beyond just increasing gilt purchases. Of the options above, we would favour number 2 initially – buying private securities. But with Governor King seemingly steadfastly opposed to any meaningful purchases of private sector securities, and the conditions for the nuclear option of deficit financing not likely to be in place in the foreseeable future, option 3 may have attractions as a halfway house. But implementing option 3 would be very close to extending the Special Liquidity Scheme (SLS), a move that King has repeatedly ruled out. For now, therefore, should further monetary stimulus be required, it is highly likely to take the form of more gilt purchases, notwithstanding all of the evidence that it is perhaps the least effective of the QE options.
Colin Ellis, European Economist
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