Bank may build on its huge stimulus package - Capital Economics
UK Economics

Bank may build on its huge stimulus package

MPC Watch
Written by Ruth Gregory

The decisive action taken by the Bank of England in the past two weeks has succeeded in easing some stresses in the financial markets. But if financial conditions continue to tighten between now and next Thursday’s policy meeting, the Bank may yet need to expand its QE programme or impose a cap on bond yields. And even if the Bank isn’t willing to countenance a “helicopter drop”, the effects of its actions may end up being similar.

  • Big stimulus package from BoE has succeeded so far in easing some financial market stresses
  • But with financial conditions still unusually tight, the Bank may need to do more
  • The Bank may need to test out some new, extreme, tools

The decisive action taken by the Bank of England in the past two weeks has succeeded in easing some stresses in the financial markets. But if financial conditions continue to tighten between now and next Thursday’s policy meeting, the Bank may yet need to expand its QE programme or impose a cap on bond yields. And even if the Bank isn’t willing to countenance a “helicopter drop”, the effects of its actions may end up being similar.

What has happened so far?

The emergency measures that the Bank has put in place so far have three main goals. (See Table 1.) First, countering the stresses in the financial markets. Second, freeing up lending to businesses. And third, helping the economy to rebound as and when households and businesses are ready to spend again.

Table 1: Bank of England Recent Policy Action

Measure

Size

Aim

1. Bank rate cut

From 0.75% to

0.10%

Help economy to rebound

2. QE

£200bn, most gilts, buy as soon as possible

Ease market stress. Help economy to rebound

3. Decrease in cost

and rise in volume

of loans in other

currencies

UK banks can

borrow US dollars

at a rate only just above zero

Reduce market stress

4 .Term Funding Scheme Small and Medium-

Sized Enterprises

Unlock at least £200bn of finance

Incentivise lending to SMEs

5. Reduction in countercyclical capital buffer

From 1% to 0%. Unlocks up to

£190bn of capital

Free up lending

6. New Commercial

Paper Lending

Facility

Unlimited

Free up lending

Sources: BoE, Capital Economics

Of these, the cut in interest rates from 0.75% to the Bank’s estimate of the effective lower bound of 0.10% is likely to be the least effective in the near term. It won’t prevent what could be a 15% q/q fall in GDP in Q2. And it will do little to help firms with liquidity and cashflow problems or to prevent financial market conditions from tightening further. The hope instead is that lower rates will support a faster eventual rebound in activity.

Meanwhile, the Bank’s quantitative easing (QE) programme has two welcome elements. First, it is at least as large or bigger than the QE packages announced in 2009 (£200bn), 2011-12 (£175bn) and 2006 (£70bn). It increases the size of the Bank’s existing asset holdings by 45%, from £445bn to £645bn. It is worth 9% of GDP, which is bigger than the asset purchases of 3.3% of GDP and 7.3% of GDP announced by the Fed and the ECB respectively in recent days.

And second, it will be completed as soon as is “operationally possible”. If these purchases were completed over three months, that would eclipse both the size and the pace of the monthly purchases in previous rounds of QE. (See Chart 1.)

Chart 1: BoE Asset Purchase Facility

Sources: Bank of England, Capital Economics

So far at least, this impressive increase in QE appears to have been successful in lowering gilt yields, with the 10-year gilt yield currently at around 0.50%, down from the recent peak of 1.00%.

There has been some respite for dollar funding markets too following the coordinated move with other central banks on 16th March to provide a decrease in the cost and an increase in the volume of loans provided to banks in US dollars and other currencies. Cross-currency swap basis vis-à-vis the dollar have narrowed in recent days.

Finally, to help businesses cope with cash flow problems the Bank has fired three extra shots. First, it has launched its Term Funding Scheme with incentives for Small and Medium-sized Enterprises (TFSME). That allows banks to borrow at least 10% of their lending to firms over the next four years from the Bank at very low rates. The Bank says that could unlock at least £200bn. Second, the reduction in the so-called countercyclical capital buffer from 1% to 0% until at least March 2022, means that banks are now required to hold less capital, freeing up another £190bn for them to lend to businesses. And finally, the new Commercial Paper lending scheme, which provides extra, unlimited, liquidity for banks.

But with the strains in the financial markets still acute, more may still be needed. 3-month LIBOR-OIS spreads have surged to their widest since the 2011/12 euro-zone sovereign debt crisis. And corporate bond spreads have gone even further. These moves have contributed to a major tightening in overall financial conditions. (See Chart 2.)

Chart 2: CE Financial Conditions Index

Sources: Bloomberg, Refinitiv, Capital Economics

This is the kind of thing that keeps central bankers awake at night as such stress is the first stage of any financial crisis. So the Bank will want to do all it can to prevent any further stages. Any more moves could happen at Thursday’s scheduled meeting or even before if the market dislocation intensifies.

What’s left in the tank?

The next step may be to increase its asset purchases. Bank Governor Andrew Bailey has already suggested that the MPC would be fully prepared to increase the size of its QE programme, saying that “it is open to the MPC to look again at [the total number of asset purchases]…it’s never closed in that sense”. And if corporate bond spreads continue to widen, the Bank may expand its purchases of corporate bonds.

Or the Bank could follow in the footsteps of other central banks and introduce a cap on bond yields. That would require it to abandon pledging to buy a set amount of assets and instead saying it will buy as much as necessary to keep 10-year gilt yields below, say 0.5%.

Is now the time for a helicopter drop?

It might even give serious consideration to the nuclear tool of “monetary financing” or “helicopter drop” – government spending/tax cuts financed by a permanent increase in the size of the Bank’s balance sheet. That would raise all sorts of concerns about over-reliance on money printing and high or even hyperinflation, as well as comparisons to Zimbabwe and Venezuela. And the Governor said on Thursday that “we are not going back to monetary financing”. It would also need to be joint Bank / government decision.

But in some ways, it appears as though it is already happening. We know the government is going to significantly boost handouts to businesses and households and finance it by issuing debt. And we know the central bank has just pledged to buy up to £200bn (9% of GDP) of government debt. So a helicopter drop is already happening in some sense! The crucial difference is that the Bank doesn’t intend to hold the assets it will buy forever. QE is temporary, not permanent. Although note that the Bank has not sold any of the assets it acquired during the financial crisis ten years ago.

Even so, if ever there were a time when helicopter money could be presented as part of a credible one-off policy to deal with an exogenous shock, then this might be it. And the lesson of the last few weeks has been that it is not long before the unimaginable becomes reality.


Ruth Gregory, Senior UK Economist, +44 7747 466 451, ruth.gregory@capitaleconomics.com