Has the Bank of England gone too far?

Any forecasts about the economic impact of the coronavirus epidemic and the drastic measures taken to fight it can be little more than guesstimates at this stage. Even so, it is clear that the Treasury will have to borrow on a massive scale as it steps in to support private businesses and workers while tax revenues fall away. But is the avowedly independent Bank of England in turn supporting the Treasury rather too much for comfort?

The scenario published on 14th April by the Office for Budget Responsibility (OBR) spelt out the staggering amount of borrowing that may lie ahead. The fiscal watchdog modelled a 35 per cent decline in GDP in the second quarter, an estimate that Andrew Bailey, the Bank’s governor, has since endorsed. Even if GDP returned to its pre-virus level by the fourth quarter, it would still be 13 per cent lower for the year as a whole according to the OBR. This would cause borrowing in the financial year between April 2020 and March 2021 to be £218bn higher than previously forecast, reaching £273bn, or 14 per cent of GDP—easily exceeding the peak of 10 per cent in 2009-10 following the financial crisis.

That’s not the end of the matter. Every year the Treasury, acting through the Debt Management Office (DMO), has to find money not just to finance its deficit—the gap between spending and revenues—but to roll over existing debt. As the bonds (“gilts”) it has previously issued come due, the DMO issues new ones to repay the holders of the maturing debt. Meeting these gilt redemptions will require additional funding of close to £100bn in 2020-21.

Given this deluge of borrowing it is natural to wonder whether the government might be tempted to put pressure on the central bank to help out. That’s why alarm bells rang when the Treasury and the Bank announced on 9th April a reactivation of the government’s historic “ways and means” facility. This is in effect its overdraft account, which came in handy during the financial crisis when it briefly reached (at the end of 2008 and early 2009) almost £20bn.

When a central bank lends directly to the state, this is “monetary financing,” in which government borrowing is funded by creating money. And monetary financing is a mortal sin for central banks, associated with disastrous episodes such as Weimar Germany’s slide into hyperinflation a century ago.

But the alarm over the joint announcement was overdone. The declared purpose is to give the Treasury temporary access to additional short-term funding other than the markets during the disruption arising from the epidemic. Any drawings on the account “will be repaid as soon as possible before the end of the year,” the Treasury and the Bank said. By 15th April there had been no extra use of the facility above its usual modest level of £370m over the past decade.

The main way in which the Bank could finance the state would be to purchase the new debt that the government is issuing. But that is not happening. The DMO continues to finance government borrowing by selling gilts in the markets.

What the Bank is doing is to buy existing bonds already traded in the markets and to pay for those purchases by creating money. It has embarked on a further extension of quantitative easing (QE), a procedure that has by now become conventional even though it breached orthodoxy when launched in Britain 11 years ago. The Bank’s monetary policy committee decided at a special meeting on 19th March to buy an additional £200bn of predominantly gilts (at least £10bn will be non-financial corporate bonds), increasing its total holdings of such assets by almost half, to £645bn.

After a decade of QE, its effects have become familiar. Far from kindling a surge in prices, as some feared when it was introduced, inflation has remained stubbornly low not just in Britain but in the euro area and America. Indeed, the main concern about QE nowadays is that it is no longer as effective in stimulating the economy, since it works mainly through lowering long-term interest rates and they are already so low. Again, then, it is hard to mount a convincing case that the Bank is going too far by resorting to yet more QE.

Even so, there are reasons to worry about the monetary-fiscal complex that has developed over the past decade. Ultraloose monetary policy has made it much easier for the government to cope with high debt. By bearing down on bond yields, QE contains the interest bill even though public debt is now far higher than before the financial crisis. For the bonds held by the Bank, the cost is even lower since they are in effect financed at the central bank’s interest rate, now at an all-time low of 0.1 per cent. The Treasury pockets that interest saving as the Bank hands over the difference between the higher yields on the gilts it has bought and its own interest rate.

The real worry lies further ahead. The immediate impact of the crisis is deflationary as people lose their jobs and demand is generally suppressed. The slump in oil prices will bring down consumer price inflation, which the Bank expects to fall from 1.7 per cent in February to below 1 per cent this spring.

But beyond the next year or so, there is a risk that the crisis could jolt the economy out of its low-inflation mindset. There will be less reliance on global supply chains, strengthening domestic influences on inflation. As weak companies go to the wall during the crisis, those that survive may gain more pricing power.

If inflation does pick up then the Bank should respond by raising interest rates. But will it drag its feet? The fear is that monetary policy may increasingly become hostage to budgetary imperatives, a condition sometimes called “fiscal dominance.” As government debt swells, higher rates could destabilise already precarious public finances, the more so since they will immediately reduce the Treasury’s interest saving on the gilts that the Bank has purchased.

Earlier this month, Bailey mounted a sturdy defence of the Bank’s independence. Writing in the Financial Times, the governor described QE as a “temporary” intervention. He stressed that the Bank’s monetary policy committee “remains in full control of how and when that expansion is ultimately unwound.”

On past form, however, that unwinding will be a long time coming. In May 2009, soon after QE had begun (and had already expanded from £75bn of planned asset purchases to £125bn), the then governor, Mervyn King, said: “The exit strategy is very simple. It’s a combination of raising Bank Rate and selling some of the assets that we’ve purchased.” But there has been no exit. Instead the direction of QE has been one way only, to ever-higher amounts.

The Bank’s policymakers may declare their institutional autonomy and individual resolve to act independently. Yet in practice the Bank will find it hard to stop propping up the state well beyond the crisis.