Compliance Code Cracker: Quantitative easing - the real “magic money tree”?

While Donald Trump recently tweeted that it would be a good idea for the Federal Reserve to engage in more "quantitative ease" (sic) The Federal Reserve's latest round of Treasury bill purchases announced on October 11 2019 is described as definitely not being quantitative easing(QE).

They state that large scale asset purchases conducted by the Federal Reserve during the financial crisis and its aftermath were concentrated in purchases of longer-term securities — principally longer-term Treasury securities and agency mortgage-backed securities and that those operations were aimed at putting downward pressure on longer-term interest rates.

The purchases of Treasury bills announced on October 11 2019, on the other hand, were described as having little, if any, effect on longer-term interest rates and other asset prices and as being likely to have little if any effect on household and business spending decisions and the overall level of economic activity.

They were purely technical operations aimed at maintaining reserves in the banking system at an ample level that supported the efficient and effective implementation of monetary policy.

Indeed, the Federal Reserve has consistently eschewed the term, “quantitative easing,” (QE) even with regard to the large scale asset purchases conducted during the credit crisis ─ preferring the term “credit easing” (CE).

They characterised the CE policy as supporting credit markets through an expansion of the asset side of its balance sheet and distinguished it from “quantitative easing” as had been used by the Bank of Japan.

While both policies involved the expansion of the central bank's balance sheet, they said, the ways in which the policy approached expanding the balance sheet to stimulate lending were different.

QE was characterised as an expansion of the central bank's balance sheet with no intentional change in its composition. The central bank undertook more open market operations with the objective of expanding bank reserve balances which could then be used by the banking system to make new loans and to buy additional securities.

CE, on the other hand, focused on the mix of loans and securities that the central bank held as assets on its balance sheet as a means to reduce credit spreads and improve the functioning of private credit markets. The ultimate objective was improvement in the credit conditions faced by households and businesses.

In this respect, they said, the Federal Reserve had focused on improving functioning in the credit markets that had been disrupted and that were sources of funding for financial firms, nonfinancial firms, and households.

“Credit easing” and the Bank of England

In their Staff Working Paper No. 825 on credit easing versus quantitative easing the Bank of England(the Bank) acknowledged that former Federal Reserve Chairman, Ben Bernanke, had first used the term “credit easing” to describe the Federal Reserve’s large scale asset purchases which had focused on changing the size and composition of the asset side of its balance sheet to support private credit markets.

In this paper, however, they were using the term “credit easing” to refer exclusively to central bank purchases of defaultable privately-issued securities, known as the Corporate Bond Purchase Scheme (CBPS) in order to distinguish it from QE, which involved the purchase of default-free government-backed securities.

The precursor to QE – the asset purchase fund facility

On 19th January 2009 the then-Chancellor of the Exchequer, Alistair Darling, stated that the Government was announcing a comprehensive package designed address barriers to lending by, inter alia, setting up an asset purchase programme (APF) implemented through a specially created fund.

He explained that the Bank would be authorised by the Treasury to purchase high quality private sector assets, including paper issued under the Credit Guarantee scheme, corporate bonds, commercial paper, syndicated loans and a limited range of asset backed securities created in viable securitisation structures.

The Treasury, he said, would authorise initial purchases of up to £50 billion, financed by the issue of Treasury bills. Given the scale of the programme, the Bank would be indemnified by the Treasury.

As part of its broader remit, a central bank is fundamentally concerned with maintaining conditions for the stable provision of financial services to the wider economy. The 2008 crisis had demonstrated that specific financial markets could sometimes fail and which that raised the possibility of the central bank stepping in as ‘Market Maker of Last Resort’ (MMLR).

The use of the APF fell within this filed of central bank activity according to then-Executive Director Markets at the Bank, Paul Fisher.

In addition, the programme provided a framework for the Monetary Policy Committee (MPC) of the Bank of England to use asset purchases for monetary policy purposes should the MPC conclude that this would be a useful additional tool for meeting the inflation target.

In such circumstances, the scale of the scheme could be expanded, and a further announcement would be made.

As can be seem from this statement, the initial purpose of the scheme was to reduce barriers to lending, but it provided for the possible future use of the scheme by the Bank of England for monetary policy purposes.

The Treasury and the Bank – independence, authorisation and consent

On 25th November Mervyn King told the Treasury Select Committee it was clear that the Bank of England Act gave the authority to set decisions on monetary policy to the MPC, and that, while monetary policy included the bank rate, it was not restricted to it.

He also warned that if got to the zero level there would need to be a close co-ordination between government and the central bank because monetary policy was very close to government debt management. However, he said, the decision-making power as to what the Bank would do would still rest with the MPC.

Powers of the Treasury to give directions to the Bank

Section 4(1) of the Bank of England Act 1946 empowers the Treasury to give directions to the Bank ─ other than in respect of monetary policy and micro-prudential supervision/regulation ─ and Section 19 of the Bank of England Act 1998 provides the Treasury, in exceptional circumstances, the power of direction in respect of monetary policy.

In terms of financial stability and monetary policy such powers have never been used.

However, with regard to the APF, in the first instance, the principal aspects of the programme did not constitute strictly monetary policy, but they did also involve issues related to fiscal policy and, therefore, required authorisation by the Treasury. For example, at that time the Bank’s balance sheet was insufficient to support the APF so there was a need for explicit HMT backing.

Furthermore, in addition to the fact that the objectives of the programme were not exclusively monetary objectives, the indemnity provided by the Treasury to the Bank fell specifically in the field of fiscal policy.

As the then Bank executive director of markets, Paul Fisher, noted there was overlap between the different policy elements involved in the use of the APF. As he acknowledged, when the APF was first introduced, the Bank was effectively operating as an agent for the Government as its the purchases were financed by the issue of treasury bills, not by the Bank, and the Government indemnified the Bank against any losses.

He went on to speculate that had the Government wanted to, the purchases could have been designed and operated purely as a fiscal operation and not implemented by the Bank. But the correspondence from the Chancellor had made it clear that the purchase of private sector assets was intended to improve the functioning of markets and so was consistent with a market maker of the last resort function (MMLR) while simultaneously providing a framework for asset purchases as a monetary policy operation by the MPC. The facility, he said, had to be designed to be compatible with that.

The APF and monetary purposes

While the scheme did provide a framework for the Monetary Policy Committee (MPC) of the Bank to use asset purchases for monetary policy purposes should the MPC conclude that this would be a useful additional tool for meeting the inflation target, this was still not designed as an exclusively monetary matter.

As Chancellor Alistair Darling indicated in his letter “given the range of assets that will be purchased and the indemnity that HM treasury is providing, financing of this facility by central bank money will require my consent.”

The start of QE

The minutes of the MPC for 4th and 5th February 2009 state that, while the MPC had up until then influenced the economy by changing the interest rate, the MPC could also influence the economy by controlling the quantity of central bank money directly by increasing the supply of central bank money in the economy through additional purchases of government securities.

Alistair Darling subsequently authorised the MPC to also use the APF to purchase UK government debt on the secondary market.

The Debt Management Office (DMO) borrows, inter alia, by selling long dated government bonds (“gilts”) to investors. Under QE the investors then sell those gilts, or their existing gilt holdings, to the Bank.

The bank credits electronically the reserve accounts of the banks. In this way if, for example, pension fund A banks at Barclays and sells £50m of gilts, the Barclays account at the Bank of England will be credited with that sum with £50m of new central bank money (clearing bank money held in their accounts at the Bank) which has been electronically created or as one commentator dubbed it, “freshly-typed.” This is the real “magic money tree.”

The Bank of England Asset Purchase Facility Fund

A subsidiary of the Bank, the Bank of England Asset Purchase Facility Fund Ltd (BEAPFF Ltd), was incorporated up on 30th January to manage the Bank of England Asset Purchase Facility Fund (the vehicle through which quantitative easing is delivered).

Its objects were cited in the memorandum of association as being to assist the Bank of England with its central banking functions. In particular, it was set up to fulfil the remit of the Chancellor of the Exchequer given to the Bank on 19 January 2009.

In terms of the specifics of the authority, it was acknowledged in the MPC minutes of February 2009 that it was the Bank, rather than the MPC which had been given the authority by the Chancellor to conduct asset purchases through the APF.

Subsequently, in terms of QE, the as National Audit Office stated in its report and accounts for 2013-4, the Bank had made a loan to BEAPFF Ltd, backed by a claim on the Bank's balance sheet. BEAPPF Ltd had used the loan to purchase assets (mainly gilts) held by investors and had effectively injected money directly into the economy.

The Treasury indemnity

BEAPPF Ltd was indemnified by the Treasury against losses and the Treasury would receive any profits generated by selling the assets back to the market or holding them to maturity. This agreement was accounted for as a derivative contract and was recognised as an asset for the Treasury.

A derivative was defined as a financial instrument or other contract whose value changes in response to the change in a specified variable that requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and is settled at a future date.

The balance represented the amount that would be due from BEAPFF Ltd should the scheme be unwound completely at the year-end ─ in effect ─ the difference between the value of the assets and liabilities of BEAPPF Ltd. As the assets held by BEAPPF were gilts, they noted, the value on the derivative would change as gilt prices moved and interest was accrued.

Purchases only permitted on the secondary market

Under Article 123 of the consolidated version of the Treaty on the functioning of the European Union prohibits the purchase by central banks of debt instruments from central governments which precludes BEAPFF Ltd from purchasing gilts at debt management office auctions in the primary market.

As a result, the purchases were made by the Bank─ as stated in the operating procedures ─ acting as agent of BEAPFF Ltd (not of the government as in pre-QE stage as stated in the MPC minutes ) ─ with BEAPFF Ltd as the principal and counterparty of the contract ─ through gilt-edged market makers and interdealer brokers on the secondary market.

A disadvantage of this system is that BEAPFF Ltd could not know the identity of the principal on the other side of these typically anonymous deals.

This means that the Treasury cannot not be sure that the extra funds being injected ─ in the form of the purchase price of the gilts ─ have found their way into the UK domestic economy as opposed to having been injected into the economy of another jurisdiction.

[View source.]

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