The Bank of England has announced that it will scale back its multibillion-pound “quantitative tightening” programme.
The process is significant for the UK economy and the public finances. But how will it work?
What is quantitative tightening?
The process is the opposite of quantitative easing – the tool used by the world’s most powerful central banks during the 2008 financial crisis.
Often referred to as “printing money”, QE involved central banks buying bonds from financial institutions, such as commercial banks and pension funds. This helped to push down yields – in effect the interest rate – on bonds, lowering borrowing costs and supporting economic activity.
In total, the Bank of England bought £895bn of bonds. Most (£875bn) were UK government bonds. The remaining £20bn were UK corporate bonds.
The return of high inflation after the Covid pandemic has led central banks to raise interest rates, as well as to begin the process of unwinding QE. For the Bank, this has involved reducing the stock of bonds held on its books through a mix of selling them to financial institutions and not replacing maturing debts.
The Bank first started scaling back its bond holdings in 2022. Over the past year it has disposed of £100bn – of which £13bn was through bond sales – cutting its overall holdings to £558bn.
On Thursday the Bank said it would slow this process from £100bn to £70bn over the coming year. However, fewer bonds will mature in the next 12 months. As a result the Bank is increasing its active sales to £21bn, even though it has a lower target overall.
Why is it important for financial markets?
While pumping money into the financial system had the effect of lowering bond yields, central banks selling their holdings can have the opposite effect. The reason is simple: increased supply drives prices down: when a big seller enters the market, prices drop. For bonds, when prices fall, yields rise.
Borrowing costs have risen across advanced economies after the Covid pandemic, reflecting investor worries about inflation, weak economic growth, and concerns about how sustainable high levels of debt are for some countries.
The Bank of England has said global factors are the main driver behind the UK government’s long-term borrowing costs hitting the highest level in 27 years. However, QT has also played a role.
What impact has QT had for the government?
There are three ways government finances are affected.
First, rising borrowing costs have added to the government’s debt-servicing bill. Second, the Bank of England has been selling its bonds for less than it paid for them. And finally, the Bank is also losing money on its remaining bond portfolio – with the Treasury picking up the tab.
The money used to buy bonds under the QE programme did not come from government taxation or borrowing. Instead, the Bank created money digitally in the form of central bank reserves. These reserves were used to buy the bonds.
In the early years of QE, the Bank made a profit on its bond holdings. This is because the interest it paid on the reserves created to finance asset purchases was lower than the income it received from those assets.
However, the return of higher interest rates has reversed that dynamic. Income from the Bank’s bond portfolio has fallen below the interest it now pays on central bank reserves – resulting in a loss for the Treasury.
The Office for Budget Responsibility forecast in March that the “interest losses” and “valuation losses” from selling bonds would result in cash losses amounting to £108bn over the next five years, almost reversing £124bn of cash profits to date.
