GIlts and QE: some questions

Following his speech (pdf) last night in which he talked about quantitative easing, Alice Cook has some questions for Charles Bean. Here’s how I would answer them if I were he:

The UK government will have to issue £120 billion of new debt [next year]. What will the Bank of England do if the government can not sell this debt without long term government yields beginning to rise?

Nothing. The Bank has no more of a target for gilt yields than it does for share or house prices. What’s more, there’s probably nothing it could do. Gilt yields are, to a very large extent, determined globally; since January 2000 the correlation between UK and US 10 year yields has been 0.78 (R-squared = 60.6%). The likeliest way in which gilts would sell-off significantly would be if government bonds around the world did so. The Bank could do little about this.

Suppose the government, in its desperate desire to run this huge deficit, allows rates to increase. As Mr. Bean knows, this will put upward pressure on all interest rates. In turn, this will crowd out private expenditure in favour of public consumption. Will the Bank of England accelerate money creation on order to keep government yields down?

No. The premise here is mistaken. The likeliest scenario in which yields rise is if global investors ' appetite for risk returns, and if they anticipate an economic recovery. But these would be circumstances in which bank lending resumes and credit spreads fall. So, far from private expenditure being crowded out, it’ll be crowded in.

What will the Bank of England do, if as is likely, investors begin to sell UK gilts as long term inflationary expectations begin to rise?

Simple. We’ll stop quantitative easing and raise interest rates. That’s what inflation targeting means.

Assuming that the Bank of England want to prevent gilt yields rising, will it begin to buy government paper in order to put a floor under bond prices via quantitative easing?

But we don’t want to stop yields rising. The assumption is wrong.

If private sector investors starts to seriously dump UK gilts, is the Bank of England prepared to become the buyer of last resort for government paper?

No. Remember here that there are two distinct reasons why investors might dump gilts - because of worries about the governments’ creditworthiness, or because of fears of inflation. The former is a remote prospect. Indeed, it’s possible that creditworthiness fears would actually be good for gilts, if investors dump Irish or Italian bonds in favour of safer UK ones.
And if the market starts worrying seriously about inflation - despite the Bank’s target - they'll pile into index-linked gilts as well as dump conventionals.  Government could address this simply by issuing more linkers and fewer conventionals.

If the UK bond market collapses completely, is the Bank of England ready to become the primary source of funding the government deficit?

The contingency is too remote to bother with. There’ll be a demand for gilts. The only question is: at what yield? Why should it worry the Bank if that yield is high, except insofar as a high yield is a signal of high inflation expectations?

When will the BoE tell the government that it wants to stop buying government paper in order to prevent the UK from drifting into a hyper-inflation?

We can tell them any time we like, and a very long time before we get anywhere close to hyper-inflation. The extent of quantitative easing is for the MPC to decide. As Mervyn King told last week's press conference (pdf):

Decisions on those operations would be as now made entirely by the Bank of England and it would be just as independent as it is now.

Of course, it is perfectly possible that the Bank will misjudge the degree of QE required, with the result that inflation overshoots its target. But this is the sort of error that happens all the time even under conventional monetary policy. Talk about hyper-inflation or a collapse of the gilt market is just hyperbole.

Comments

[Guido Fawkes]

Everything is fine, nothing to worry about.

In the money markets "all is for the best in the best of all possible worlds".

[chris]

I'm not saying there's nothing to worry about.
I suspect - FWIW - that gilt yields will be higher in two years' time than now. But this is because economic recovery will raise inflation expectations (a little) and cut risk aversion.
I wouldn't be surprised if real yields around the world rose, longer term, as the Asian savings glut fades and as worries about US government debt rise.
But to talk about hyperinflation or the collapse of the gilt market - as if the UK were alone in the world in increasing public debt - is just silly exaggeration.

[David Heigham]

Beutifully put for those questions. I think Charlie Bean will read that with appreceiation.

[JKA]

Hi Chris
You are very patient.
Charlie also said. "We don't have to keep on cutting rates to provide a stimulus" and last week the Governor said "further rate cuts what's the point". So no guesses on rate direction.
But CB doesn't quite have the script, QE is that which the BOJ did not so well. We take Obama's lead, we are all into Credit easing now, quite a different proposition. Like communism and capitalism, the one dog eat dog, the other quite the reverse.
JKA

[Luke Lea]

Hi!, I'm new to this, directed here from the Times Online top 100 blogs. Checked 'em all and yours was the only one that stayed on my bookmarks.

Though I have a strong background in economics, I know little (or knew little before the meltdown) about banking and finance. Though I have learned tons, I still have tons to go, and you seem like a very intelligent fellow who writes well and seems to know what he is talking about. Your commenters are also exceptional. I am looking forward to an education. Any pointers for basic background?

[CP]

I wish I shared your confidence that the BOE and the government will manage everything correctly. This seems like a bit of a stretch, considering past performance (same for the US and elsewhere).

Are you saying that hyperinflation isn't possible if lots of nations "print money" at the same time? Please explain.

[Andrew Duffin]

"The Bank has no more of a target for gilt yields than it does for share or house prices."

True, without a doubt.

But the government will have a target (whether published or no) and the Bank does what the Government says.

So your "it's all OK" answers don't comfort me at all.

The inflationary beast is stirring: we have zero interest rates, rampaging monetary growth, and a government desperate to keep the Merry-go-Round turning for another fourteen months or so.

Trouble is coming. Check back in 2011.

[JKA]

Andrew,
The market not the government has a target for gilt yields which reflect as Fisher tell us, inflationary expectations (2% CPI target) plus a real rate risk premium of around 200 to 250 basis points.

The programme of credit easing as opposed to quantitative easing is designed to expand liquidity within the system by asset swops, more easily reversed than reclaiming the cash dropped from a helicopter. Check out QE v CE what's the difference. JKA

[JimH]

You seem to have a great deal of confidence in the BoE, an institution that didn't manage to predict the current crisis, or do anything to prepare for it. If I, a mere layman nobody, could see this crash coming before 2007, why couldn't the big nobs in the BoE? And why should I trust them now? I'd be better off going and finding someone who predicted this mess, and seeing what they would do. And I doubt it would be QE (the PC way of describing printing money).

[Mark Wadsworth]

I read this far ...

"The likeliest scenario in which yields rise is if global investors' appetite for risk returns"

and gave up. Surely the reverse is true? Over the last five or ten years banks has 'appetite for risk', i.e. were prepared to lend vast amounts of money for little security and interest rates were 'too low' (or they were with hindsight). So 'appetite for risk' reduces interest rates rather than increasing them.

[tbrrob]

Why are you so confident the government won't default?

Government spending/borrowing is ultimately backed by the tax payer. And if we can't produce enough the government is screwed.

I don't think we'll default because the next government will be forced to seriously cut spending.

But the potential is there.