Sunday, June 28, 2020
After the bailout, Bailey plots the Bank's exit strategy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt.

When Andrew Bailey became governor of the Bank of England in March, the usual description of this Threadneedle Street veteran was that he was the ultimate safe pair of hands and a model of discretion. Mark Carney, his predecessor, had developed a reputation for generating headlines, and was happy to wander beyond his brief. Bailey, it seemed, would keep himself within the Bank’s solid walls.

This theory suffered a rather big blow a few days ago when the new governor generated headlines suggesting that Britain almost went bust in March but was saved by the Bank’s exceptional actions. At a stroke, Bailey out-Carneyed Carney and knocked his predecessor but one, Lord (Mervyn) King, out of the park.

The suggestion that the country could have gone bust a few weeks ago has produced an outbreak of harrumphing from economists, Bank veterans and others. Was the Bank doing in March 2020 what the International Monetary Fund did in 1976, bailing out the British economy at a time of great difficulty?

No, but I do not blame journalists for running with the story. You do not look a gift horse in the mouth and the governor’s remarks, in an interview with Sky News, were hard to resist. There was, he said, a “pretty near meltdown” in core financial markets and, had the Bank not announced more quantitative easing (QE) and other measures: “I think the prospects would have been very bad. It would have been very serious.”

It would also have been serious, he suggested, for the government because “we would have a situation where in the worst element, the government would have struggled to fund itself in the short run”.

Critics have pointed out that, ultimately, governments can always fund themselves, the question being at what price. The markets, in other words, would have soaked up whatever gilts (UK government bonds) the government needed to issue to fund its borrowing, if there terms were attractive enough.

This, however, rather spectacularly missed the point. If the government was only able to get its funding away at a high interest rate then that high interest rate would have percolated through to rest of the economy, scuppering the efforts of the authorities to keep short, medium and long-term interest rates down. It would have sent out a confidence-sapping signal and increased the damage to an economy already facing a significant hit.

The Bank’s additional QE, the £200bn in March and a further £100bn this month, has been timed to coincide with the period of maximum pressure on the public finances as a result of the furlough scheme and other emergency measures to support the economy. Those who get twitchy about Bank apparently working so closely with the government and worry that it might be compromising its independence should note, as Bailey did in a letter to the chancellor on Thursday, in his capacity as chairman of the Bank’s financial policy committee, that “the committee attaches great importance to its secondary objective of supporting the government’s economic policy, and will continue to have regard to the impact of its policies on the government’s economic objectives”. You can be independent and still very helpful.

As it is, thanks to the Bank, the government has had no difficulty funding its extraordinary borrowing, which will break all records this year, even managing to do so on occasion at marginally negative interest rates.

It has been hard to keep Bailey own in recent days, and of more importance in the long run than the fuss over whether the government could have funded itself or not were his comments in an article he wrote for Bloomberg, the financial news and information service.

Headed ‘Central Bank Reserves Can’t Be Taken for Granted’, and with a sub-head ‘The current scale of central bank balance sheets mustn’t become a permanent feature’, the article set out the case for unwinding this year’s emergency QE once the crisis is over.

This, you will recall, has not happened before. The Bank announced its initial £200bn of QE in March 2009, with further tranches later, including in the aftermath of the Brexit vote in 2016. None has ever been reversed, and this year’s additional £300bn takes the running total up to £745bn, equivalent to between 35% and 40% of Britain’s annual gross domestic product.

The Federal Reserve, America’s central bank, did embark on a process of unwinding some of its QE but had to stop, even before the coronavirus crisis, because of the damage inflicted on the economy by Donald Trump’s trade wars.

Now, however, Bailey is looking for a way to reverse it. He, and presumably other members of the Bank’s monetary policy committee (MPC) are starting to feel uncomfortable with the size of the Bank’s balance sheet.

As he put it: “The current scale of central bank reserves mustn’t become a permanent feature. As economies recover, it’s likely that some of the exceptional monetary stimulus will need to be withdrawn, including by reducing reserves. This wouldn’t take us back to the very low levels of reserves before the financial crisis, which sometimes failed to recognize the role they play in ensuring the stability of the financial system. But elevated balance sheets could limit the room for manoeuvre in future emergencies.”

One thing that has held the Bank back from unwinding any of its QE is that it had applied a rule that reversing QE should only begin when interest rates had risen. The initial target level of Bank rate for this process to start was 2%, later reduced to 1.5%. At a 0.1% Bank rate, we are a long way away from that.

This rule always seemed to me to make unwinding QE unnecessarily difficult. I have argued here on a number of occasions that the Bank should adopt a “last in, first out” approach. QE was undertaken only after interest rates had been cut to what were regarded as rock-bottom levels. Unwinding it should have been the first step on the road back to normality.

That, it seems, will now be the Bank’s approach. “When the time comes to withdraw monetary stimulus, in my opinion it may be better to consider adjusting the level of reserves first without waiting to raise interest rates on a sustained basis,” he said.

That makes a lot of sense. We can debate how much the Bank’s intervention saved the country from a much worse fate. I hope most can agree that unwinding some of this year’s large-scale actions will be an essential step on the road back to normality.