The Bank of England has spent its valentines with a QT

If you are one to pay attention to macroeconomics you can’t have missed the Bank’s new infatuation with Quantitative Tightening (QT) - she’s been all the rage - and for this year alone, the Bank has decided to reduce its bond holdings by another £100 billion, bringing total reserves down to £658 billion. In plain English, this means that instead of ‘printing money’ through Quantitative Easing (QE), the Bank's monetary tightening measures have effectively extinguished the so-called “magic money tree.” 

Of course, this layman's explanation does little to clarify how the modern banking system - which sometimes does work like magic - actually functions. Like most things in life, the truth of how banks create and destroy money is complicated, but it looks something like this. Rather than relying on savings, banks loan money depending on the demand for credit from credit-worthy borrowers. By the stroke of a pen (this is the magic bit), banks effectively ‘create’ money out of thin air and then loan that money to the one who demands it. 

Even this explanation has its caveats. Say you take a loan from the bank. When the bank creates this loan, it is seen as an asset on their balance sheet as the loan is ‘owned’ by the bank and you owe the bank the loan. On the other hand, deposits, the money in your bank account, are seen as liabilities to the bank as the bank does not own these and instead has to produce the sum of these deposits on demand, hence, a liability.

However, when banks create money through lending, they don’t just increase their assets - that would quite literally be a magic money tree - they, again, by the stroke of a pen (or more appropriately, an Excel spreadsheet), add a corresponding liability entry so that assets are equal to liabilities. Hooray, a balanced balance sheet! Yet, because of this liability entry, should the loans turn ‘bad’ and no longer be classed as assets, assets no longer equal liabilities, and the bank must effectively dip into its profits to cover these losses. 

So the world works, loans are only created when credit-worthy borrowers need them and commercial banks can't just continue making infinite money without any consequences. With the majority of money in the economy being created by commercial banks, this process dispels the myth that when the central bank creates money, it somehow functions as a ‘helicopter drop’ into people's pockets. This is not possible. Money creation from the central bank in the form of purchasing government bonds (QE) does not magically insert new money into the economy as the supply of money grows in line with the demand for money itself. 

Yet, this does not mean that QE has no impact on money creation whatsoever. If it didn't, it wouldn’t be a useful tool for central bankers. QE impacts the economy through two channels. The first is based on credit supply as QE dampens bond yields, which serve as a benchmark for interest rates. When these fall, credit becomes cheaper, allowing banks to lend to borrowers who may have previously been unprofitable. In the second channel, QE stimulates credit demand by making people ‘feel’ richer. This is because once pension funds sell their bonds to the Bank of England, they use the new cash from the sale to reinvest into other financial assets like corporate bonds or equities that you and I may own, making us richer by increasing their value.

However, both of these channels still depend on the ‘real’ economy. Banks are only willing to lend if they are confident that creditors will repay their debts. Conversely, borrowers are only willing to borrow if they are certain of their future incomes and capacity to repay debt. As such, it’s not that QE itself creates inflation; instead, it simply accelerates existing inflationary trends that are down to strong market confidence. This is precisely what happened during the pandemic as broad money growth and inflation surged.

Attentive readers will notice a big surge in money growth (M4) during the Financial Crisis; explaining why this was not inflationary requires an article of its own.

Unsurprisingly, the Bank of England got a lot of blame for this from many commentators (including yours truly). However, many of these criticisms do stem from a misunderstanding that QE functions more like a money printer. Of course, as I have outlined, QE does not force money to ‘appear’ in the economy out of thin air.

I mention this as the Bank of England hate train has continued throughout their Quantitative Tightening (QT) programme. QT is just the opposite of QE. Instead of buying bonds from pension funds to stimulate money demand and by implication money supply, the Bank sells the bonds it owns to reduce the supply of money in the economy. 

The negative press reception to QT has been split into two parts; monetarists, and what I will call ‘tax wonks’ (because to understand this you are either a central banker or a huge nerd). The monetarist view predicts that the Bank’s tightening programme will have deflationary consequences. I find that this is misguided as it is based on the presumption that the Bank has a strong influence over the money supply, which, as we have already discussed, is not the case. Even if one takes an altered monetarist perspective that focuses on QT depressing the demand, and thus supply, of money through accelerating existing negative growth trends, I still find the potential for deflation unlikely. UK labour markets remain tight despite rising company insolvencies and as such, money demand and economic activity will persist, albeit at a lower level. 

Now let's see if the tax wonks are better judges of character when it comes to giving the Bank advice on its newfound love. These commentators, including the Treasury Committee, have made the argument that the Bank’s QT programme will lead to increased costs to the taxpayer. However, proponents of this line of argument are a little confused. Despite what some commentators may suggest, QE and QT operations on their own do not create any losses for the taxpayer. When the Bank of England sees “losses” on its QE/QT programmes or even gains for that matter, these just represent internal transactions between the central bank and the treasury. The treasury pays interest on bonds to the central bank, which, after covering its costs (including any losses from bond sales), returns profits to the treasury or manages losses incurred. This circular flow of funds means that, at a consolidated level, there isn't an additional loss; rather, it's a redistribution of existing obligations. 

This does not mean that government debt has no cost, it certainly does. But the cost is not down to the composition of government obligations, rather, it's down to the higher interest paid on these obligations. That is the bill that taxpayers will be footing. 

All articles and opinions posted give the views of the author(s) and do not necessarily reflect the views of the Leeds Think Tank, the Leeds University Union, or the University of Leeds.