The Great QE Rip-off

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0:40Thanks for listening to A Long Time in Finance with Jonathan Ford and Neil Collins.

0:49Neil Collins: Every central bank experienced something like a financial nervous breakdown in response to the Covid epidemic. All around the world these key institutions were buying in their government stocks, injecting cash into flailing economies to prevent recession turning into slump. Yet none did so with the vigour and determination of the Bank of England. Under the label of quantitative easing, the bank bought in government stock which had been issued in those strange days when interest rates were near zero. Those stocks had very long lives and paid the holder a tiny dividend, sometimes one percent or even less.

1:33Neil Collins: Then inflation finally accepted the invitation offered by this nearly free money and arrived with a vengeance. Eventually QE gave way to QT, quantitative tightening, where central banks sold the stocks they had bought back into the market. But the prices were very different. For example, in May 2020 the bank bought in some 2061 stock, in other word stock maturing in 2061, paying just 0.5%. They paid£101 for this stock. Earlier this year, it sold back that same issue for£28. Now, buying something for£101 and selling it for£28 is not a clever trade. With us today is Christopher Mahon, Senior Fund Manager at Columbia Threadneedle, who has done some scary sums on this subject for the FT over recent months, spelling out just how big the loss to the taxpayer is.

2:35Neil Collins: Perhaps we can start with why QT was thought necessary after the Covid crisis had passed and ask why the Bank of England's policy has been quite so extensive compared to other central banks. You're absolutely right to cast your mind back to the dark days of both COVID and, of course, the post-Lehman's crisis financial period when QE, quantitative easing, started. And those were both quite bleak periods economically. In many central banking circles, there was a lot of panic about what to do. Would this create some kind of Great Depression? That was quite a worry back in 2008 when the banks were going bust.

3:17What would happen if you just turned off the economy as we did during COVID? And a huge amount of pressure was applied to all parts of policymakers to try and help. And ultimately, what they ended up doing was, of course, quantitative easing buying, government bonds, as you say, and hoping that that would somehow essentially push money into the system and boost the economies. The interesting thing about what the Bank of England did is just how differently it designed its quantitative easing program relative to those central bank peers. It bought far longer maturity bonds. It bought far more government bonds, whereas other banks tended to diversify their holdings.

4:00The ramifications of all of this have been quite startling. On our numbers, for instance, the Bank of England has lost about 5.4 % of GDP on its QE program, which is about four times worse than the US Federal Reserve. So that's a huge, huge number.

4:19Neil Collins: Christopher, how much of that is in actual money rather than as a percentage? That's£115 billion on the Bank of England's official numbers. To put it in context, in the upcoming budget that Rachel Reeves is due to unveil in November, she's looking for about£20 billion of savings. So we've got£115 billion of QE losses, and that's against 20 billion of savings which the Chancellor is looking for. You said we did it differently to other central banks. In terms of what we bought, you say that we bought a lot of long-dated bonds and you also said they diversified. Can you just sort of unpack that a bit and explain what everyone else was doing?

5:01So at first glance, if you compare the Bank of England against the Federal Reserve, both did similar amounts of QE in aggregate. The Bank of England did about 40 % of GDP across the whole period from 2008 to 2021, where the Federal Reserve was only a little bit less at 35%. So broadly, similar numbers. And at first glance, you might think, well, that's where the story might end. But actually, when you delve into the details, it is quite different. So within the Federal Reserve, only about half of their holdings were in government bonds. The rest of their holdings were in very different types of securities, corporate bonds, mortgage-backed securities, even inflation-linked bonds.

5:44So they had a much more diversified portfolio of assets. By contrast, the Bank of England largely bought government bonds. 98 % of its program was just government bonds. So it was much, much more concentrated into that one sector. And they tied their fortunes, if you like, to what would happen to the government bond market, whereas the Federal Reserve had a much more diversified approach.

6:07Neil Collins: Now, that's not the only difference, because not all the government bonds were the same. So the government bonds that the UK Central Bank ended up buying were much longer in maturity than the Federal Reserve. And that meant they locked in the low rates, those zero interest rates from the COVID era for a much, much longer period of time. So this is surely the starting point where things have gone really wrong. Why do you think they bought so many long-dated bonds at prices that I would describe as ridiculously high? I think ultimately it was an inadvertent consequence of trying to keep things simple.

6:46The Bank of England tried to buy the gilt market in a quasi-passive fashion. In other words, just buying equally along the curve. By contrast, the Federal Reserve was much more targeted about where they would buy. Sometimes they would buy the front end, sometimes they'd buy the back end, they would switch around a bit, they were much more proactive. The Bank of England was trying to keep things simple. But as any fund manager will tell you, the gilt market is famously the longest maturity government bond market in the world. So when you buy things passively, you don't end up with something that looks like any other government bond market, you end up with something which is actually twice as long in terms of maturity profile as what the Federal Reserve ended up buying.

7:24What they, as I say, I think inadvertently ended up with was a book which was about twice as exposed to government bonds as the US. And the government bonds were about twice the maturity. And that's why they end up roughly with four times the level of losses.

7:39Neil Collins: But I still don't understand why they didn't just leave the long end of the bond market, which was so clearly grossly overpriced. A lot of us said so at the time. It was absurd that you would be able to borrow money, the UK government could borrow money at 1 % for 30 years. That was fantastically cheap money. Why didn't anybody in the bank turn around and say, we really shouldn't be buying this stuff in, we should be concentrating on the shorter end, which would have a very similar effect in terms of its impact on the economy. I think you're absolutely right about that. It is quite remarkable that they continue to buy with such vigour all the way through that 10-year period.

8:25I think you can probably extend your comment to the mistake of not matching what they were buying to the needs of the UK economy. So as an example, in the UK economy, we tend to have things like two to five year mortgages, two year or five year mortgages. That's the norm in the UK. A fixed mortgage, you mean? A fixed mortgage. In the US, by contrast, they tend to have 30 year fixed mortgages. So if you're trying to stimulate your economy, in the US, you get much more bang for your buck by stimulating the 30 year part of the curve, that's going to really help bring mortgage rates down. Buying the 30-year part of a curve in the UK doesn't really benefit very many people other than perhaps the Treasury.

9:11But really, there's no companies who borrow for 30 years. There's no households who borrow for 30 years. So it's quite a strange thing to be doing. Again, I think one of the mistakes they made was not tying what they were buying to the needs of the economy. Do you think that QE then, in its effect, I mean, people have argued endlessly over this since 2009 didn't achieve what it set out to do or did less well than other comparable economies which are doing the same thing? It's certainly pretty hard to argue that in the case of the losses being four times worse than, say, the US, that the benefits were four times bigger.

9:44I mean, it's pretty hard to argue that. It would seem that if you were looking at a value for money lens, the UK has definitely had a worse time of it by a long way. Can I ask another question, which is the flip side of Neil's point about this is a terrible deal. You buy them for 101 and then you sell them for 28, which is why does the Bank of England, with the consent of the government, which is after all, the owner of the Bank of England, not run these bonds to maturity? So I think to answer that question, you've got to step back in time to the end of the QE era. The end of the QE era was essentially marked by all these banks having big balance sheets and the UK central bank in particular starting to draw a lot of public criticism for its actions.

10:29For much of the previous 10 years, QE had sort of flown under the radar in certain policymaking circles. But finally, by the end of 2021, policymakers were starting to get quite anxious about all of this. The House of Lords, in fact, wrote a report that ended up being something of a bombshell called Addicted to QE. And they made some pretty remarkable criticisms of the central bank of how it had bought so many government bonds. And this sort of public rebuke, I think, scarred the Bank of England and the pendulum swung the other direction really quite hard. So within a matter of months, they were talking about reversing QE and were publicly committing to doing things which other central banks were not, to kind of go cold turkey, if you like, on what the House of Lords had called its addiction.

11:19And they ultimately ended up committing to this unique practice of selling gilts, almost to show that they're not addicted to it and they can go much further and faster if needed.

11:30Neil Collins: But if anybody can sell something at a silly price, did it not occur to them that this was going to crystallise these losses, which they were always going to get as a result of paying to buy these long-dated, essentially zero-coupon stocks. Why did they then feel the need to crystallise this particular loss? And why hasn't it caused much more embarrassment to the people at the bank? Neil, you quoted the price of the 2061 bond. It's quite interesting to trace the evolution of those prices. So back in the day during QE, they were buying that 401 pounds, that bond. When they first considered selling it, when they first considered selling a gilts back in May 2022, the price was 61.

12:20By the time they actually got around to deciding that they were indeed going to sell, the price had fallen to 36 pounds. And by the time the actual auction results were in, the price ranged from about 25 pounds to about 30. The price was declining on them all the time. And yet just last month, they comment in their monetary policy report that sales have only been conducted in appropriate market conditions. So it is quite sort of, you know, hear no evil, say no evil type of logic.

12:53Neil Collins: That stock now stands at 25. But they do have an countervailing economic pressure on them in that when they created QE or they did QE and they purchased government bonds, they created liabilities at the Bank of England which needed to be funded. So there were reserves held at the Bank of England by commercial banks on which the Bank of England paid interest. And that interest is fluctuating unlike the fixed government bonds that they were buying. And is that not the case that the cost of running these bonds to maturity has been climbing in recent years? Yeah, absolutely. So to recap the mechanics, under QE, the bank borrows cash from other financial institutions, high street banks in the main, to buy the bonds, and they pay the bank rate, currently 4 % on those bonds, they have locked in the yield, in many cases 1 % or so, on their purchases.

13:56So it's a classic sort of carry trade, if you like. They've borrowed short and they've bought long. That's kind of how it works. It is the case that at times that will be something which is accretive to the bank's balance sheet and at other times is loss making. Certainly when the bank first announced quantitative tightening, i.e. the sale of the gilts, what they were paying on their cash rate was of your order of magnitude 4 % to 5%. And what the bonds were yielding was perhaps 3%. In other words, it was a negative carry position. And as a result, it would make sense to close that out as quickly as you can.

14:36But the situation today is quite different. Today, that 2061 bond that Neil quoted is yielding about 5.5%. And the cash rate today is about 4%. So it's positive, Carrie. So the point which I've been trying to make in some of my articles is when they talk about appropriate market conditions, they should think about the shape of that curve and whether or not it really does make sense to be closing it down or whether they should be running it to maturity. And right now it makes sense to run to maturity.

15:07Neil Collins: Yeah, well, it's clearly cheap money, although it's nothing like as cheap as it was of course when they were buying them in. I think you've used the phrase the incurious monetary policy committee. I can't understand why they just seem to have swallowed this and thought well it's not our problem because the bank has a guarantee from the government indemnity against losses as a result of QE and QT and nobody appears to have taken a step back and saying, you do realise that the sums involved here are of real, genuine losses over the transactions are very large indeed. Christopher, you might also just explain the losses and who they fall on.

15:56You're absolutely right. If you cast your mind back to the dark days of 2008, the then Chancellor Alastair Darling and Mervyn King agreed an indemnity for the Bank of England. And that indemnity would essentially make taxpayers pick up the tab for the costs. And in some senses, it is that indemnity which has driven some of the actions of the Bank of England. Governor Ramsden, who is one of the main architects of the quantitative easing and tightening policy, He has used the quote quite a few times that the Monetary Policy Committee does not take into account the financial profits or loss in its decisions on the asset purchase facility.

16:41In other words, they don't think about the financial ramifications. As far as they're concerned, that's something for the Treasury. Now, I find this quite remarkable for a civil servant to say. As I say, I think it's an over-interpretation of the word indemnity. If I indemnify my builder not to do a bad job, it doesn't mean to say, you know, I want him to try all sorts of experimental techniques. You know, if it all goes wrong, you know, it's only me to blame. I want him to try his best. And obviously, if it goes wrong, well, obviously, I'll pick up the tab. But this idea that the financial profits and loss are not something that the Bank of England thinks about is quite remarkable.

17:19Neil Collins: Can you just remind us again, your current best estimate of the cost of all this to the taxpayer? So we think this has cost about 5.4 % of GDP. In terms of the costs of quantitative tightening, particularly, that is around 16 billion pounds of extra costs that they put on the taxpayer, using their own estimates, which are quite mild. If you were to use independent research, it's around£60 billion of extra costs onto the taxpayer. Those are lifetime costs, so they're not for one year, but they are big numbers either way. Just to recap what I think you've been saying to us, you've been saying basically that the Bank of England, which is in possession of an indemnity from the government, which means that any losses it makes on these QE sales, QT sales, will be filled by the taxpayer.

18:14The Bank of England is deliberately, it seems to me, from what you said, engaging in sales practices that enlarge the loss to the taxpayer, because they are careless of the outcome. Some of the losses, I have to say, you seem to accept were caused by virtue of the poor structuring of QE in the first place. But my question is, why is the Treasury, which is the owner of this institution, or the government, which is the owner of the Bank of England, and therefore presumably in a position to express its own views to the governor, not expressing views to the effect that stop making unnecessary losses, which will increase the government's deficits.

18:54We don't know what they say behind the scenes. We only have the public record. And the public record is very mild, with the exception of a few reports by Treasury select committees, which may contain certain references to what you and I are discussing. But in general, when the Chancellor then writes up those reports, The Chancellor, whether that was Jeremy Hunt or whether it is now Reg Reeves, generally takes a much milder tone. And the rationale that I would suggest is this is the post-Liz Truss environment. No one wants to challenge the Bank of England after that mini-budget debacle. Treasury does not want to go toe-to-toe with the Bank of England.

19:32That's not going to come off nicely, so they want to keep their head down.

19:35Neil Collins: I find it almost incredible. I really find it incomprehensible that this major supposedly independent organisation seems to be incapable of any sort of constructive thought on such an important issue. Out of this wreckage, where do we go from here, Christopher? So the Bank of England next is going to meet and decide on its quantitative tightening envelope, as they call it, on September the 18th. They review these things once a year. A lot can happen in a year and prices can change quite remarkably in a year, as we were talking about earlier. But nevertheless, they do it once a year. And they've got a few options.

20:13The consensus expectation is they will reduce the total amount of quantitative tightening, but they will expand the amount of guilt sales. Now that sounds strange but it's a function of how much passive, how much maturities, how many maturities you have anyway. That's the sort of consensus is this reprofiling of the whole thing but will still involve the quantitative tightening that we've been talking about, those active sales that we've been talking about. Now I think they could go quite a few steps further without causing any red faces anywhere. For instance, they could reprofile if they wanted to just sell at the front end.

20:51Neil Collins: You mean the short-dated stocks rather than the longer-dated stocks? Exactly. They could reprofile to just the short-dated maturities. They could also, if they really wanted, stop completely. There's no reason why they need to continue. So those are the things which I would hope they are going to be debating in some detail in their September the 18th meeting. We'll have to wait till then to see what to do. But as I say, the consensus is that they're still going to continue at least doing things pretty differently to other central banks. Several times you talked about long and short dated bonds.

21:22Perhaps you could explain why the latter long dated bonds are much more sensitive and volatile to changes in interest rates than the short dated, which I think is behind why it would make more sense to sell only short dated bonds. Every year, the government has to raise money and it can raise money either a short dated area, the medium dated area, or a long dated area. They can choose how long to lock in their rates for, if you like. And they normally do a mix of all those things. But they also have to take into account whether there is demand at each of those points, whether there are buyers for their securities, for their debt at each of those points.

21:59And right now, across all markets, not just the UK, long dated government debt is having a pretty tough time of it. Long dated government debt from the US, from the Eurozone, from the UK, it's all underperforming. It's all getting pretty illiquid. There are fewer and fewer natural buyers out there for that type of security. And the perilous state of public finances in many countries, not just the UK, is causing some investors to focus their purchases on shorter dated securities where they don't have to worry about whether the country is still going to be around in however many years. So that's a general theme globally, what it has meant is securities like that 2061, roughly a 40-year or so government bond that Neil was talking about, that type of security, they've been really underperforming.

22:46It would make a lot of sense for the Bank of England not to continue to push more and more securities and sales that way, where they can leave a really big footprint in a pretty illiquid part of a curve. They could, if they wanted, concentrate their sales on a much more liquid part of the curve at the front end, the five-year point, the seven-year point, that type of thing. The government is selling a lot of guilts at present. Some people have questioned the wisdom of QT simply on the basis of if you're selling a lot of guilts into the market to raise money for the government, why are you flogging a lot of bonds which will raise zero money for the government but will effectively use some of the appetite that the market has in doing that?

23:27Do you think that that's a valid criticism or do you think, as the bank has suggested, that, well, we talk to the debt management office, we figure out things so that we don't damage the market? So, so far, the Bank of England has sold about 100 billion of gilts into the market. It thinks it hasn't had much footprint in terms of disturbing market prices. I would say that it is quite a naive statement to make that you haven't had much impact. There's very few markets in the world where can sell 100 billion of anything and not leave a trace behind. The bank rather belatedly has started to acknowledge this criticism.

24:04So back in 2023, when they started out, they reckoned that their actions were putting up yields by, and I quote, less than 10 basis points. And today, they reckon it's between 20 and 25 basis points. Again, I think that independent research would suggest those numbers are at the low end of the spectrum. The National Bureau of Economic Research put out a piece last year that reckoned the actual impact was two or three times that type of level. But as I say, that's not acknowledged, at least yet by the Bank of England.

24:39Neil Collins: So that's getting on for 1 % more, the cost of issuing new debt. Their figure is, I think, 70 basis points, so 0.7%, yes. That's a kind of serious figure, that is. Exactly. That's where our figure comes from, that the actions of the Bank of England have raised the cost of debt servicing by between 16 or 60 billion pounds over the next 30 or 40 years. It's 16 billion if you think it's the bank's number of 20-25 basis points. It's 60 billion if you take the National Bureau of Economic Research number of 70-odd basis points. So if the Bank of England did the sort of sensible thing, could they eliminate the loss or could they just reduce it?

25:20So all that is locked in now. What they could do, though, is avoid making these mistakes in future years.

25:26Neil Collins: That sounds far too much like common sense to me to actually happen. Don't be so gloomy. You've got to give people the possibility of succeeding. You know, you talked about the lending envelope. I must say, if it was down to me, I think I'd be issuing envelopes with something else in if I was trying to reform the MPC, which seems to me to have lost its way dramatically. And it's very hard to see how they can plausibly explain their conduct on this. So we need a better MPC and more sensible people in charge. That seems to be the conclusion. Well, I think we need some people who are prepared to think and use their judgment rather than saying, oh, well, we've got a treasury guarantee, so let's just carry on.

26:15Neil Collins: I think it's a disgraceful episode. And I think their tactic clearly is to hope that nobody's noticing. That was A Long Time in Finance with Jonathan Ford and Neil Collins. Production and editing by Nick Hilton. If you enjoyed the show, please rate and review it on your podcast app, as that will help new listeners find us.