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MNI INSIGHT: Rate Squeeze Would Limit BOE Bond Runoff

MNI (London)

Strong demand for reserves leaves the Bank of England unsure how far it will be able to reduce its balance sheet after it begins quantitative tightening.

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The Bank of England's balance sheet is likely to stay elevated for the foreseeable future, as emerging details of its newly-modified tightening strategy indicate that reductions of its stock of gilts may have to stop at a hard-to-determine point when the drain on central bank reserves starts to push market interest rates uncomfortably high, MNI understands.

Drawing lessons from the Federal Reserve's experience of its round of quantitative tightening in 2017, the BOE calculates that it should be able to run down its balance sheet for some time without pushing up the cost of market funds if it clearly communicates that QT should not be interpreted as a signal of the future direction of its benchmark interest rate. As the Fed discovered, however, eventually such pressures do materialise when reductions in holdings eliminate too many reserves, and the BOE agrees, though the point at which this will occur is not clear.

Following criticism by a House of Lords committee, which accused it of a lack of transparency regarding its quantitative easing programme, the BOE's economists last month produced a ream of analysis on bond buying, and Andrew Hauser, executive director markets, provided further insight into the Bank's thinking in a speech on Sept. 13, indicating that when the BOE begins quantitative tightening it is going to have to feel its way to an appropriately-sized balance sheet. This will come after reaching a "level of reserves supply … below which central banks cannot go without driving short-term market rates up above policy makers' target levels," he said.

While QE unwind would not need to end at that point, balance sheet shrinkage would, according to Hauser, as the Bank would have to start replacing the long-duration gilts with shorter-term repos or other operations. This level of balance sheet, while well below the current near GBP1 trillion, may still be very elevated as demand for central bank reserves appears strong in a period of high uncertainty and low rates.

SHADOW BANKS

At first everything ran smoothly when the Fed signalled a QE unwind in 2017, and when it began in October the yield curve flattened. Later, though, financial institutions' preference for central bank reserves, including heavy demand from shadow banks, exerted pressure on rates.

The BOE's strategy is to commence QT via natural run-off once Bank Rate rises to 0.5% from its current 0.1%, allowing gilts its holds to mature without replacement. But the markets department will keep a close eye on demand for reserves.

An earlier tightening strategy, recently revised, would have only started balance sheet reduction at 1.5%. The adjustment came as the BOE indicated it was adding negative rates to its policy toolkit, and was intended to allow it to rely less on bond purchases in future rounds of easing.

The Bank, though, has given no estimate of the so-called Effective Lower Bound of rates. Much of the problem is that, as is the case with the optimal level of its balance sheet, the level of the ELB would be determined by the unpredictable reactions of the financial system to its policy. While research from the European Central Bank and others has found that negative rates were successful in continental Europe, members of the BOE's Monetary Policy Committee disagree on how much British banks would pass on sub-zero rates to customers.

MPC member Silvana Tenreyro has said she thinks Bank Rate could go to at least -0.75%, but views within the Committee could range widely, with the ELB seen as being anywhere from barely negative levels to as low as -1%.