Since March 2009 the Bank of England (BoE) has been engaged in an experiment to stimulate the UK economy. The experiment was commenced in the aftermath of the credit crunch when banks stopped lending to each other because they were no longer certain of the creditworthiness of their counter parties, ie. other banks. The economy was in recession with negative GDP growth at -4.3%, and inflation at -0.53%. The Bank had reached what it felt was the lower bound of what it could do with interest rate policy having taken Bank Rate down to 0.5%.

Enter Quantitative Easing) the experiment which involved the BoE creating money and using it to buy assets, overwhelmingly, government debt. The goal was to increase the level of liquidity, ie. money, in the economy. Buying government bonds (government debt) from banks achieved this in two main ways:

First, it increased the cash banks held as they sold the bonds they held to the BoE which theoretically would encourage them to lend the cash to secure a return.

Secondly, by increasing demand in the bond market it pushed up the price of bonds which had the impact or reducing their yield, broadly the fixed rate of interest paid on the bond which obviously goes down if you pay a higher price for the bond and up if you pay a lower price.

As bonds are seen as virtually risk free the rate for bonds effectively sets the lower benchmark for all interest rates thus putting downward pressure on rates making borrowing money cheaper. The benefit of this is that, in theory, it encourages people to borrow and invest in productive assets thus stimulating growth in the economy.

In the years that followed the UK economy did begin to revive peaking at 3% GDP growth in 2014, slowly falling back to 1.7% in 2019 then collapsing with the advent of Covid. Given the patchy and declining performance and subsequent collapse of the economy, QE was continued and now amounts to a £895bn of bonds on the balance sheet of the BoE.

Interestingly, £875bn of the total, or 98%, is government debt, ie. bonds issued by the UK government. Given that the bank is wholly owned by the UK government this appears to mean that c37% of the government’s national debt is owed to the government! Interesting debate with Modern Monetary Theory around this.

However, we are now in a changed economic environment dominated by rising inflation and the spectre of stagflation. Given this the BoE has had to change direction and is “unwinding” QE, replacing it with Quantitative Tightening (QT). No one seems to know what the effect of this will be. Some worry that the market for bonds may be undermined and their price fall dramatically. This would have the reverse effect of the purchase programme pushing interest rates up throughout the economy. To some extent this is the intention but the fear is that it may not be a process which can be regulated. Once the tap starts to be turned the market will jump.

The problems this might create are compounded by the long period of ultra low interest rates. Cheap money looking for a home often finds one which is riskier than the investor thinks. When rates go up and the tide of money recedes they are caught swimming in the buff. For businesses this is more than embarrassing, it is a matter of life and death.

If QT happens on the QT everything may be ok. But if suddenly you start to hear a lot about it we could be in even worse trouble than we are at the moment.