In two months’ time, the US Federal Reserve is expected to begin the next phase in the greatest economic experiment of modern times. America’s central bank has signalled that it may start unwinding quantitative easing in September with the piecemeal sale of the $3.5 trillion of bonds bought since QE’s 2008 launch. No one quite knows what happens next, but the gloomiest predict another financial maelstrom.
One thing is certain. Borrowing costs will rise and the Fed doesn’t even need to press the button. Effective interest rates in Britain, Europe, the United States and across the world are going up and central banks won’t have to do anything.
It was Martin Feldstein, Ronald Reagan’s chief economic adviser and now a Harvard professor, who made the observation. Between 2013 and 2016, the four big central banks — the Fed, the European Central Bank, the Bank of Japan and the Bank of England — bought more of their governments’ debt than those governments issued, he said. This year, the sums will roughly balance. In 2018, though, “new issues by the governments will significantly exceed purchases by central banks by an amount equal to about 2.5 per cent of the GDP of those countries”. This “enormous” shift will have “an important effect of increasing the real long-term interest rate”.
The big event here is not the decision to unwind QE but simply to stop doing any more. The Fed ceased buying assets in late 2014, the Bank finished after Brexit and the ECB plans to quit in December. That leaves the Bank of Japan. Having purchased more than $10 trillion of government debt since the financial crisis, the biggest buyers are leaving the marketplace almost entirely.
Without their main customer, governments will have to offer investors a better price. That means higher interest rates and it’s already happening. Government bond yields, used to price everything from fixed-rate mortgages to corporate loans to pension schemes, have jumped. Since June, the yield on ten-year UK gilts has risen from below 1 per cent to 1.275 per cent. The same is happening in US and German bonds.
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Against the backdrop of automatic global monetary tightening, a Fed decision to flood the market with more bonds would lift borrowing costs even higher. Last week Ian McCafferty, a Bank ratesetter, said that the UK should be having the conversation, too. At the moment, policy is to leave the £435 billion stock of QE (a third of gilts in issue) unchanged until official rates are about 2 per cent. There could be advantages to unwinding it earlier, Mr McCafferty suggested.
Pension funds need higher bond yields to close the £180 billion hole in their schemes, which could release money for companies to invest. Bank profitability would improve by resuscitating the old model, crippled by QE, of making returns from borrowing short and lending long. It might afford better deals for savers. Distortions caused by QE to rescue the economy in the crisis, which are now arguably damaging it, could be undone.
There is another issue. With rates at record lows, QE transfers profits to the Treasury and reduces the gilt issuance required to fund the budget deficit. As rates rise, though, the equation reverses and the Treasury has to issue more debt to fund QE’s losses. According to the Office for Budget Responsibility, if rates hit 4 per cent the Treasury will have to issue an extra £80 billion in total.
Over the life of the scheme, the state will roughly break even, but the gains have been booked already and the costs will come just as rates rise, potentially amplifying the effect of tighter monetary policy. Even if the Bank decides to take a passive approach and let gilts mature, doing so would remove £62 billion of buying power over the next two years. However you look at it, short of a crisis, borrowing costs are on a one-way trajectory now.
Philip Aldrick is Economics Editor of The Times