The BoE’s Confused QE Kerfuffle

Ah, August. Long known in the news world as “the silly season” for being the time when everyone important is on vacation and reporters have nothing of substance to work with, today it gave the world a treat: actual silliness. As you might have seen when perusing financial news, there is a wee dust up between the Bank of England (BoE) and House of Lords, which published a report recently questioning whether the BoE’s quantitative easing (QE) program was “a dangerous addiction.” This choice of words triggered BoE Governor Andrew Bailey, who spouted off in a press conference today. Most coverage focused on his taking issue with the word “addiction” in light of very real societal problems in that arena. In our view, everyone focusing on that war of words misses the real curiosity: a bigtime central banker stating he thinks flattening the yield curve is stimulus.

The saga started in January, when a Lords committee including former BoE Governor Mervyn King determined QE “has not been subject to sufficient scrutiny, including in Parliament, given its size, longevity and economic importance.” So they conducted an investigation, taking testimony from numerous witnesses—BoE officials, economists and other noted experts. We found this amusing from the start, as we think QE does more harm than good—as we will discuss shortly—and King was responsible for launching it in the UK back in 2009. How fun, we thought, if he led the committee that determined the whole thing was a fruitless exercise!

Alas, while the report (available here), wasn’t glowing, it didn’t get all the way there. It concludes that QE wasn’t stimulus and that central bankers seem to like it more than experts do: “The evidence shows quantitative easing has had limited impact on growth and aggregate demand over the last decade. To stimulate economic growth and aggregate demand, quantitative easing is reliant on a series of transmission mechanisms that operate primarily in and through financial markets. There is limited evidence to suggest that these increase bank lending or investment, or boost consumer spending by wealthy asset holders.” On a second question—whether QE bond purchases amounted to the BoE monetizing UK government debt, the BoE got poor marks for bad communication and the uncanny timing of its policy announcements and the Treasury’s evolving debt financing needs. While the report stopped short of an outright accusation of backroom skullduggery in violation of the BoE’s apolitical mandate, it warned the appearance of deliberate debt financing risked the BoE’s credibility.

After Bailey’s rant about the title, it became clear that last part was the biggest bee in Bailey’s bonnet. He railed: “You can’t discriminate among borrowers. Every borrower benefits from it, and every borrower includes the government. We’re not doing it for the government.” Which, ok, sure. Government borrowing costs are the reference rates for mortgage, consumer, personal and business loans. If government borrowing costs fall, then society’s costs fall. Yet one could easily argue this is a happy byproduct of overt debt financing, so it doesn’t address the issue of motive, and we therefore don’t award debate points.

But here is the real fun part, the rest of Bailey’s quote: “It’s the yield curve. It’s there and all borrowers are on the same yield curve.”

So here we see a central banker outright acknowledge that QE flattens the yield curve—never mind confess that the flatter yield curve was the goal. We have long wondered if central bankers were just totally zoned out and forgot the yield curve when they decided buying bonds to reduce long-term interest rates—while holding short rates near zero—was a good idea. Now we have the real answer: At least in Bailey’s case, as he extended his predecessors’ QE policies, the yield curve flattening was deliberate. It seems he believes this is stimulus.

We admittedly haven’t read every central bank proclamation ever published, but off the top of our heads, we can’t recall a central banker ever calling a flat yield curve stimulus. Over 100 years of economic theory (and data) holds the opposite: Steep yield curves are stimulus. We think that viewpoint is correct, as big gaps between short- and long-term interest rates widen banks’ net interest margins on new loans. The more profitable lending is, the more banks will do it, funneling money into the economy and fueling growth.

This is partly why people usually get worried when the yield curve flattens or inverts. Back in 2019, the flattening and, eventually, inverted US yield curve was a top concern among central bankers, economists and financial headlines, who saw it as a sign of a slowdown ahead—or worse. Yet when it comes to QE, weird blinders set in. For instance, the Lords report’s chapter on QE’s effectiveness had zero mentions of the “yield curve.” Zero! QE blinders make people who otherwise know better forget that steep yield curves stimulate. Apparently, they make central bank chiefs cheer flat yield curves as stimulus, while most observers nod along.

That leads us to today’s bizarre predicament. Before Bailey’s press conference, the BoE updated its plan for unwinding QE once the current program reaches its limit. Previously, the Bank had said it would stop reinvesting the proceeds from maturing bonds (thus letting its balance sheet shrink) when its benchmark rate was at 1.5% (versus 0.1% now). Today, it announced the unwinding process will start when the benchmark rate is at 0.5%. That follows ample chatter about when the Fed will “taper” and eventually stop its own QE program.

Pundits on both sides of the Atlantic warn this risks to removing stimulus too soon. What they don’t see is that when central banks buy bonds—whether by adding to or maintaining the size of their bloated balance sheets—they sedate economies by flattening their yield curves. In our view, that explains the anemic lending cited in the Lords report. When central banks get out of the way, long-term interest rates become subject to market forces only. The absence of artificial pressure enables them to rise if conditions warrant, steepening the yield curve and bringing actual stimulus. Yet we have an upside-down world where people think a sedative is stimulus and dread something that would be genuine stimulus.

So, public service announcement: Inverted yield curves are bad. Flat yield curves are a snooze. Steep yield curves are a party. Got it, Governor Bailey?