The Bank of England faces significant potential losses on its balance sheet as it unwinds quantitative easing. However, higher interest rates are not the source of these potential losses. Failure to raise interest rates decisively increases the risks of a steeper sell-off at the long end of the curve for Gilts. The potential losses will be much greater, if the Bank of England’s inflation targeting credibility is further damaged.
The real problem lies with not unwinding QE well before the pandemic, when inflation was around target and unemployment was heading to historic lows. The Bank of England over-reacted to Brexit. The authorities have failed to address the dangerous, long-term drift towards risk-taking within pension funds (itself a consequence of QE). When financial markets convulsed in the early weeks of the Covid pandemic, the Bank of England, it would appear, had little choice but to intervene.
But the Bank of England has to bite the bullet and show some courage: if it should intervene again to bail out markets, as it did with the Dash for Cash, it will set the stage for even deeper problems further down the line. QE can only be a secular policy if governments are prepared to use fiscal policy adroitly, to bear down on the term premium for government bonds.
That is palpably not the case today, in either the US or the UK. Self-interest groups are able to plead their case with ease: the UK government bends in the wind. There is scant fiscal discipline. With unemployment this low (in the US and the UK) and inflation this high, governments should be running significant budget surpluses. The Bank of England needs accept that the unwind of QE will cause problems (in financial markets) in the short, even medium term. But, by sending the right message to the Government, and markets, it will be better for long-run financial stability.
