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Tomasz Wieladek is chief European economist at T Rowe Price and a CEPR Research Fellow.
Alongside its decision to cut rates by 25 bps, the Bank of England released an updated analysis of the impact of quantitative tightening — unwinding the asset pile created by its crisis-era bond-buying — on gilt yields and the macroeconomy.
The Bank’s models suggest QT is going basically fine: it estimates that Asset Purchase Facility reductions account for only 10–20 bps of the rise in the gilt term premium:
The Bank also judges that the macroeconomic effects of QT are small:
And that, as a result, any changes in Bank Rate required to offset these changes are also likely to be small. Indeed, the August Monetary Policy Report says it is “unlikely” that the effects will be “larger than expected”:
Clearly, the Bank is confident that it can continue to whittle down the APF — through both active sales and by allowing gilts to mature without replacing them — without much market turmoil.
But are the effects of QT really so small as to be negligible? Any time series estimate is only as good as the data and the time period used for the estimate. If there is an important mitigating factor during the time the estimates were obtained, which models don’t take into account, any estimate will under or over estimate the effect of QT.
To assess whether any QT estimate is reasonable, we need to go back to theory. QE has several transmission channels, but the main ones are the market stabilising channel, the policy signalling channel and the portfolio rebalancing channel. QT is implemented in calm market times and — at least in the way the Bank is framing it — doesn’t have any relation to macroeconomic policy.
Therefore, the only channel through which QT can work is portfolio rebalancing. In other words, QT’s impact is to raise the amount of bond supply that the private sector needs to absorb. This is because central banks tend to be price-insensitive buyers and sellers. They buy and sell regardless of the price. But private sector buyers are more sensitive to price — when the amount of bonds they need to absorb changes suddenly, yields are therefore much more likely to move as well.
This means that the size of any QT effect depends mainly upon how many more bonds the private sector has to absorb, and how fast that happens.
But this is an area where the UK is very different from the rest of the world. The rise in net bond supply to the private sector has been much smaller than would have been expected as a result of QT alone. Between 2021 Q4 and 2023 Q4, the Bank of England’s holdings of gilts shrank by £131bn. Normally, private sector buyers would have had to absorb this additional supply. But at the same time, foreign official sector buyers bought £132bn worth of gilts.
Of course, foreign official sector buyers always hold some Gilts for reserve currency purposes. Normally, this moves slowly. It took a decade to rise £178bn to £298bn before QT. But it rose from £298bn to £430bn between Q4 2021 and Q4 2023, so the pace accelerated by a factor of five. Overall, this means that foreign official sector buyers soaked up the QT sales, offsetting any clear pricing effects over this time period. The change in net supply to the private sector, as a result of public sector sales and purchases, was zero during this time period.
Foreign official sector holdings were therefore an important mitigating factor of QT in the past two years. The UK’s DMO doesn’t provide data on foreign official sector holdings. Instead, these data on foreign official sector holdings of Gilts are provided by the IMF in a spreadsheet on its website here.
The IMF provides the data with a six-month lag. As a result, it is hard to estimate what precisely happened in the first half of this year. However, foreign official sector investors already hold a very large amount of gilts relative to history, so it would seem unlikely that they increased their holdings significantly. If we assume that foreign official holdings remained constant all of this year, but QT proceeded as planned, then the total amount of bonds the private sector would have to absorb as a result of public sector sales and purchases is £62bn. This is only 32 per cent of the Bank’s total reduction in gilts thus far.
Are these effects included in the Bank’s estimates of QT? The Bank provides some details on its models. They mainly rely on yield curve data, either to measure the announcement effects directly or estimate term premia from yield curve models. There is only an indirect role for net supply effects within this framework, which would be measured in the term premium component of the Bank’s model. Indeed, the MPR says that term premia may reflect Gilt demand and supply, but doesn’t link this to QT. This is behind the Bank’s judgment that although term premia rose by 75 bps, the QT component of this is likely to be small.
However, there is no discussion anywhere in the MPR of foreign official sector buyers as a potential mitigating factor of QT effects, despite the very large size of these effects. This suggests that the effects of net foreign official sector buyers are therefore not included in the Bank’s estimates of QT.
Foreign official sector buyers have acted as an unexpected sponge for the QT bond splurge. Is it therefore so surprising that Bank estimates show that the policy’s effects have been small thus far?
Probably not. However, foreign official sector buyers are unlikely to come to the rescue again: history would suggest their appetite for gilts is likely already satiated. This means that future rounds of Bank of England QT could likely have much larger effects, perhaps three times greater than the current estimates.