BOE INSIGHT: BOE MPC QE Unwind Approach Called Into Question

By David Robinson

     LONDON (MNI) - The Bank of England Monetary Policy Committee will come

under fresh pressure to rethink its approach to unwinding quantitative easing

following the publication of central bank research papers bolstering MPC member

Ian McCafferty's view that policymakers should review their stance.

     The MPC's current approach is that it will not start to reduce its stg435

billion stock of gilts purchases until Bank Rate rises to 2.0%, a level that

market pricing suggests will not be reached over the next five years. A working

paper from one of the BOE's top economists and corresponding work from the

European Central Bank makes the case for commencing unwinding before pressing

ahead with rate hikes.

     McCafferty, who is scheduled to speak later Thursday, said in an interview

back in July that the MPC ought to review its policy of not touching its asset

purchase pile until Bank Rate reaches 2.0%. Neither he nor any of his MPC

colleagues have addressed the issue publicly since then but it is a topic that

is not going away.

     A top Bank economist, Richard Harrison, Senior Advisor in the Monetary

Assessment and Strategy Division, published a paper on optimal quantitative in

late September that broke new ground by creating a formal, welfare based

framework for assessing approaches to QE.  

     Harrison's model will be seen as a framework for future discussions,

forcing dissenters to lay down in details their disagreements with the

conclusions.

     One of the the results from Harrison's model was "that it is optimal to

start reducing the stock of QE before the short-term policy rate has been

increased from the zero lower bound."

     This finding was similar to that derived by economists Matthieu Darracq and

Michael Kuhl at the European Central Bank. In work published in November last

year they concluded that optimal policy behaviour was to stop QE and to begin to

unwind it at or before the date of lift-off for the policy rate. 

     The results of Harrison's model, which explored the differing stock and

flow effects of asset purchases, were compatible with what has happened so far

in the evolution of QE.

     He found that entry into QE regimes can be swift, with large scale asset

purchases getting underway as soon as the policy interest rate hits the

effective zero lower bound. The way out of QE, he noted, is a more prolonged

affair.

     "Exit from QE is slower in order to mitigate the costs of changes in

portfolios" and in Harrison's model it should start early in the process.

     The MPC's current approach, however, was spelled out back in the November

2015 Inflation Report. It stated that the committee wanted to use Bank Rate as

the active policy instrument until it reached a level from which it could be cut

materially, and that this level was reckoned to be around 2%.

     The committee did give itself scope to tweak that policy, stating that the

appropriate level for Bank Rate to reach before being cut depended on a range of

factors that were likely to change over time, including the likely impact of

policy changes.

     One option for the MPC would be to cut the level of Bank Rate it deems

needs to be reached before unwinding from the currently envisaged 2.0%. It would

need a substantial cut, as, on the OIS curve the BOE uses to extract market rate

assumptions, it only reaches around 1.25% five years ahead.

     Another option for the MPC would be to do a more comprehensive rethink and

to allow QE unwind to run concurrently with interest rate hikes. Rather than

selling-off gilts, it could start to reduce its stockpile of gilts by ending its

approach of maintaining the stock of QE by replacing maturing gilts.

     If the MPC does not change tack, it would run the risk of doing nothing to

reduce its asset purchase mountain throughout the entire looming tightening

cycle. 

     Harrison's model, unlike others, builds in the assumption that QE has an

upper bound. In the UK under QE the BOE has already purchased around half of the

long-term debt stock and, as Harrison notes, some financial institutions have to

hold long-term safe assets for regulatory requirements, so the upper limit on QE

has to be less than 100% of long-term gilts.

     If the MPC does not reduce QE in this tightening cycle, the next time it

wants to restart asset purchases it will be starting from a high base and could

run up against the regulatory issues.

     McCafferty, as an independent member of the MPC, could step up his calls

for a rethink. Or the Bank could leave new Deputy Governor Dave Ramsden, who was

instrumental in the Treasury's work on QE before switching to the Bank, to take

the lead on the issue.

     With Bank research raising questions about the BOE approach and with the

current policy looking close to "perma-QE" and the first rate hike expected in

November, the internal and external debate over QE unwind looks set to

intensify.

--MNI London Bureau; tel: +44 203-586-2225; email: les.commons@marketnews.com

[TOPICS: M$B$$$,M$E$$$,MT$$$$,MX$$$$,M$$BE$]