It was a great to have Chris Marsh join me on this latest Exorbitant Chat in which we discuss:
The growing public awareness of central bank losses on their QE portfolio.
How the world has changed radically since Bank of England plans for balance sheet runoff were made in 2021. Those plans may no longer be appropriate.
BoE policy sees sales of Gilts averaging three to three and a half billion pounds per month at a time of precarious public finances.
The distinguishing feature of BoE QE was the Indemnity given by UK Treasury for future losses. Those losses are now being paid for by Treasury, meaning a direct fiscal call on the government.
This approach differs from plans announced at other central banks, even those with indemnities, such as the RBNZ and BoC. In the latter two cases, indemnities sit as a derivative on balance sheets and, in theory, may never lead to a cash call on the government as central banks are inherently profitable.
The Fed appears to have the most highly developed plans for losses, which still have fiscal implications, but less onerous than at the BoE.
The Fed’s plans to stem losses imply its balance sheet will remain very large at least for the next 5-10 years, around 20% of GDP. This seems likely for all central banks yet is not being discussed.
The balance sheet itself may be used to address the enormous monetary overhang left from policies of 2020-2022, yet there are no discussions around this matter.
The discussion is a great opportunity to introduce monetary analysis into economic analysis in central banking.
Meyrick Chapman
Hello, this is Meyrick, Chapman at Exorbitant Chat, and I'm really happy to have Chris Marsh with me today, Chris and I have quite a long-standing association we used to work together at a previous shop that I worked at. And we've worked intermittently together since on various macroeconomic problems and issues. And today, Chris and I are going to talk about losses on central bank balance sheets, and in particular, we're going to look at the Bank of England's balance sheet. Chris has worked at the IMF, worked on programs in the Baltic countries. He has worked in markets directly for the last decade, together with a number of different funds, and is currently best known I think, for his work on the GeneralTheorist blog, and also for his work with Exante data. So thank you for joining me, Chris. And I think this is going to be a really interesting conversation.
Chris Marsh
Yeah. Thanks for having me, Meyrick. Yes. Thank you.
Meyrick Chapman
Yeah. So I think the the issue of losses from QE are just beginning to hit the headlines. There was an article in The Telegraph last week. I'm not sure there's been an article in the Sun yet, but there may be. So it's really getting into the public domain. This is something which we've looked at for almost a year, if I, if I remember correctly. We started a discussion about April last year. And it hasn't gotten any better since then. So could you just briefly talk through what you think the main discussion points are here and be what we should be thinking about?
Chris Marsh
Sure. So well, I guess we can begin by noting Quantitative Tightening is now sort of the baseline for most major central banks across the world now, and we're sort of mainly going to focus on the Bank of England here whereas you know, both of us being in Britain and taking particular interest in that case. But it's now sort of a common theme across central banks, whereas for most of the last decade, quantitative easing was the was the sort of main policy tool that people fell back on when they reached the zero lower bound. And I think that the observation I would make and I'm sure you would, as well, is that where where we are today is very different to where we expect it to be even two years ago, when we were when Qt was being planned initially. And the world is very different in at least two important ways. Right?
Chris Marsh
The first one is it's now becoming clear that the losses on the QE portfolio as as this rolls off, given that the reserves that are associated with QE have to be financed at the bank rate. The losses are going to be pretty substantial. So to put this in context, I'm drawing on your work here. You know, the losses could be three quarters of a percent of GDP for for maybe three years and then quarter percent of GDP for maybe three or four years. And then so cumulatively, we're talking maybe 150 billion could be more could be a bit less, but it's clear that the numbers are large. And this was totally sort of unexpected, as I say, at least two years ago.
Chris Marsh
The second thing, the way it's changed is that obviously the inflationary backdrop is greater, is much different to anything we've expected I think when the strategy for plan for QT was laid out by the Bank of England initially. So we obviously don't know exactly what they had in mind. But when we were escaping the zero lower bound, it was probably hopeful that we might have a sort of a gentle period of reflation where we hit target for for two or three years, and that would be when QT would be initiated. And inflation rate would be sort of at or maybe slightly above target in those kinds of leaving QE sort of world and leaving the zero lower bound world whereas actually the world we're in is one where inflation is close to 10%. Now slightly below. And so, I think given the QT in the Bank of England's case was the strategy was, was devised in the summer of 2021. In fact, it was published in August of 2021. When the inflation rate incidentally just checked before this podcast inflation rates at that point was 3%. Now it's in excess of 8%. So we're in a different world. And so it's worth asking whether the QT strategy in terms of the tightening overall tightening strategy of the Bank of England makes sense. So I think those are the main ways I would frame it in terms of how the world is different.
Meyrick Chapman
Okay. Yeah. I think it's worth just highlighting that our our discussion probably today is not going to be aimed at the political economy aspects of of QT and the losses associated with that, by and large, it's probably, it's probably likely that that will feed its way into the conversation, but by and large, I think we're talking about technocratic and technical details of the program and how it would how it has been devised and how it looks in the current environment. Would that would that be right?
Chris Marsh
Yeah, exactly. I mean, I think we're coming at this from the perspective of people who think about economic policy, outside of the political economy as it were just saying, what what's what's the right thing to do if we had a clean slate and thinking about the markets as well? Obviously, there's a long way between necessarily what's been agreed and what will be the ideal world, but I think it's worth exploring that and one thing that seems to be characteristic of policy in the UK, maybe more generally, is that quite often people don't, don't take a step back and ask what would be the right thing to do? In terms of policy,
Meyrick Chapman
So what do you what do you main, can we pick apart perhaps how the policy is seems to be currently organized, and what may be need in need of some revision?
Chris Marsh
Sure. So I apologize for the rain. By the way, the weather has not been very good today. I mean, I'm in a kind of a shed, so I'm avoiding avoiding the rain, but it's quite noisy. So we might be useful to begin sort of recalling what their strategy is for the Bank of England right? And this strategy is set out in the August monetary policy report is box A it's about two and a half three pages of explanation. And it boils down to sort of three points. So the first one is that they prefer to use bank rate as their main policy tool. So balance sheet is not really the the marginal tightening tool at this stage. Secondly, they think that QT and in terms of quote, “If conducted in a gradual and predictable manner, when markets are functioning normally, they think that the impact was like too small on the overall stance of monetary policy”. And the logic, therefore, is that it can sort of happen in the background. And can can sort of happen and they can just rely on the bank rate to set policy. And then the third thing is that at the time they outlined the sequencing for QT that they would not reinvest, first of all, until the Bank Rate reached half percent, which happened pretty quickly and then they will begin outright sales of gilts once Bank Rate reached 100% And, and obviously that's 100 basis points. And that's where we are today Bank Rate exceeded that a while ago and so, they moved into in the summer into the into the world of actual outright shrinkage of balance sheet both by not really investing assets, and by outright sales of Gilts in the market. So. So basically, I think that last summer, they outlined that they were going to try they're going to shrink the balance sheet 80 billion over 12 months. So we're just focusing on the asset purchase facility now and sort of sidestepping the issue of the emergency purchases in the mini budget crisis. So they're going to shrink balance sheet 80 billion over 12 months, roughly half of that is because they're not going to reinvest in maturing assets. And so they've got to roughly spin off about half of that, or 40 billion due to outright sales in the market. So that comes down to about three, three and a half billion of Gilt sales per month on average over the year, but they can be very flexible so that market notices that accompanied all of this work basically said look we can we can be flexible, we don't have to sell, they're going to wait you know, if we think the pricing is wrong, they're not gonna they're gonna withdraw the the offer and so forth. So there's, you know, there's, there's a lot there, but in actual in essence, they think it can happen in the background, and it's kind of largely irrelevant. Maybe I'll pause there before I can argue, argue as to why I think that there may be quite a case to question, this strategy, but maybe you have any thoughts yourself on this?
Meyrick Chapman
Well, I think one of the things that stands out is that the decision by the Bank of England to engage in sales, to me seems quite idiosyncratic, and potentially it's, it's hard to say it's dangerous about given the the fiscal landscape has changed quite a bit. The growth outlook looks worse than we've had before. The investor outlook for buying bonds is much more challenging than it was when this policy was devised in August 2021. And altogether, you know, I think, you know, I would just go back to your point, and it just seems perfectly sensible point to make that these plans were made in much sunnier times and look as if they could do with serious revision. So I, I also, I know we're going to talk about how other central banks are dealing with this, but I think it's even at this stage. I think it's worth pointing out that the Bank of England is something of an outlier in its determination, both to make sales and also to account for losses in but not quite real time. But but to to, to book those losses and look for payments through the indemnity and that's an area which you and I have talked about a lot and find so I think you would agree is somewhat problematic. So shall we move on to get Can we move on to talking about the indemnity?
Chris Marsh
Yeah, sure. I mean, I guess that's that's where was most exciting, the most interesting, exciting part because, you know, there was a fiscal impact here. So it hits it hits the headlines, people, people obsess over it. The numbers sound huge when when you put them into you know, if you drop them into public conversation, people sort of panic about such large numbers, especially at a time when you know the health the public services are struggling that the NHS is struggling that there's cause for public sector pay rises in the the Bank of England making losses. So it really is the optics of it's pretty bad. But I think you could also argue the economics is pretty bad, right? So you know, I think that the case for that they're making losses, but we know that they don't necessarily have to those losses don't necessarily have to be realized immediately from the fiscal perspective. So it can be something that can be swept under the carpet for a bit. Yet, the Bank of England has not isn't all that arrangements between the Bank of England and the Treasury are not not allowing that to happen. And one thing that's kind of interesting or maybe slightly frustrating is that the indemnity originates from the period of the Great Financial Crisis right when Mervyn King was governor in the QE was going to be initiated for the first time, and it's all rather murky, but what we do know is that that the arrangement the agreement to do QE was only undertaken by the Bank of England and Mervyn King on the on the guarantee that there'll be an indemnity in case there were losses and what exactly the motivation at the time was, it's not clear whether it's just the you know, didn't want to be sort of left in red faced if there were losses if Mervyn King, if there were losses and Mervyn King's governor or whether there was a genuine, deep sort of economic concern about these losses is not clear, but what we do know is that other central banks that have partly because they moved more slowly on this, but came to decide on how to deal with the losses that would happen, have done so in a different way and also done some so over a longer horizon so Meyrick, I think you will note against this. From memory, I think the Fed only decided on how they're going to deal with these in maybe 2013 2014 When they started publishing about their their strategy.
Meyrick Chapman
Yeah, yeah, I think I think that's right. But one of the things that does stand out for me on the attitude of the Bank of England, at least in their published submissions of published opinions about the balance sheet implications of QE losses or QT losses as we are as we now see them is that the Bank of England has, in on several occasions, indicated that it is concerned about how it its credibility would be affected if it was seen to sustain losses on its balance sheet that would affect materially affect its capital. That's quite, that's quite different to the approach that other central banks seem to have and it's it's odd that the bank seems so nervous about its balance sheet stability. For instance, there's a document entitled Financial Relationship Between His Majesty's Treasury (when this was published, it was Her Majesty's Treasury), but Financial Relationship Between His Majesty's Treasury and the Bank of England, in which the Bank states, "the floor of Bank of England capital will be set at a level below which the credibility of the bank's ability to deliver its mission would be insufficient jeopardy to warrant timely action". And that that seems to be as far as I can tell, one of the primary reasons for justifying the indemnity which they've obtained from the government, for money to be transferred from the Treasury to the Bank of England, so it's almost a bank saying, Well, we are in some ways, more important than the Treasury. And that's, that's a as far as I can tell, that's a unique perspective on or a unique nervousness by the Bank of England.
Chris Marsh
Yeah, I agree. I mean, it was gonna say certainly differs from the approach taken taken elsewhere and we might my comments on my memory on the the subclause you've just mentioned about capital, about the need for a recap under under circumstances where the capital falls too low. I think that agreement may post dated the actual indemnity, but still was maybe something that was kind of implicit. In the in the financial arrangements between the Treasury and the Bank of England for a long time. And so they kind of shored that up, if you like in the last decade, and I remember when they did it thinking, Well, you know, there are circumstances where the Bank of England can quite reasonably run a negative capital for a period of time. And there's no panic to have a recap of course, at the time, they already had the indemnity. So it wasn't that risk, but But what it points out is that even if the identity didn't exist, once the Bank of England started to make losses anyway, then that capital rule would be triggered, and the Treasury will end up having to recap them anyway. And that sort of recap basically would involve providing them with sort of interest bearing securities, I guess, that would essentially replace that would be it'd be equivalent to the Treasury issuing debt anyway, so either Any way you look at it, the Bank of England has sort of got two lines of defense in its in its financial accounts or financial affairs from from losses that will drive its capital negative. But as we've mentioned, this is different to how the accounting is done elsewhere. So I know Meyrick, you've sort of done a you've scanned across the different experience in other countries, so maybe it's a good time to sort of explain how this is thought of in different jurisdictions.
Meyrick Chapman
Yeah, well, other central banks publicly at any rate, don't see any threat to their credibility. The Fed as you as you mentioned, the Fed has discussed an item on his balance sheet called a deferred asset since at least 2014. It may, it may have predated that, but I found a reference to it back to 2014. So it kind of begs the question as to why the Bank of England thinks that it's different and why it's so nervous, and I I mean, personally, I feel like there is some lifting of the veil here about the nervousness of the actual personnel in charge of the Bank of England at the time that the indemnity was, was initiated. I mean, of course, this was everything was new. Back then. 2009 and the world was a very scary place. So maybe it was necessary, then, but there seems to have been no subsequent discussion as to whether it is still relevant. The RBNZ, the Reserve Bank of New Zealand, I was gonna say the RBNZ, but that's not necessarily known to everybody, but the Reserve Bank of New Zealand, and the Bank of Canada, the Central Bank of Canada, both have indemnities in a similar form to the Bank of England, in fact, as far as I can tell, it looks as if it's, they're modeled on the Bank of England indemnity, they occurred much later, and they were initiated around the time of the pandemic, so about a decade after the Bank of England's indemnity, but, but the treatment of the losses is, appears to be quite different, and it's evident on already on the central bank balance sheets of the Reserve Bank of New Zealand and the Bank of Canada. That losses have already been taken and are booked on the asset side as what appears to be a derivative form. And it's not clear from any of the writing that any cash ever needs to change hands on that on that balance sheet item. So although it's an obligation of the government to the central bank, that presumably appears in the government accounts as a liability and appears on the central bank balance sheet as an asset, it doesn't appear that any money ever changes hands and that, that that loss will be eroded over time through seigniorage. So practically speaking, that actually is very similar to the Feds approach of a deferred asset. Of course, in in any case, it doesn't matter how you book it. Central banks generally, every year make some transfers to central government, which is which is the seigniorage and the profitability of a central bank, which is a natural consequence of it's it's central part of the in the monetary system. But of course, if you're making losses and you're trying to erode, erode those losses through your seigniorage there will be no transfers to the central government, that that's the case for the Fed for the all central banks that are making losses, so there is everywhere a fiscal impact in that there'll be less money transferred to central government, but the Bank of England is, as far as I can tell. is unique in that it is, as you say, issuing debt right now, to cover losses which we all know that in the medium term, central banks are profitable in their own currency. What central banks do to their currency is a different issue, but their profitability should be assured in their in their own currency. So that I think that's I think that's an interesting. It would be nice to have the Bank of England explain why it is so nervous about its credibility being affected by losses sitting on its balance sheet. i It doesn't seem to have affected other people.
Chris Marsh
Yeah, exactly. I mean, it's, I mean, it's worth so just to dwelling on the on this point about the accounting for a minute because it can be can get lost, right? So Well, the way the Fed does this is that if it makes losses, so if it pays more on its reserves than it's receiving in its coupons on the asset side, then the way essentially pays for that is by printing, more reserves, so the Fed expands its liabilities, it's really can easily do to cover it some losses. And then on the asset side, it posts a deferred deferred asset. And then then that deferred asset is paid off over time when when that profit and loss situation at the Fed deteriorates, sorry improves again and then obviously in the future, when they're making profits again, monetary income was seigniorage and then they're not giving transfers to the Treasury anymore. They're just paying off its previous, the money it's previously printed. So in a way they print money now and then shrink that money later. In the UK's case we print we issue more Gilts now, and then later on, we would have to issue fewer Gilts because we're getting the profit sooner. So it's just an intertemporal. It's just a sort of intertemporal shifting of the relative of the liabilities of the government in the UK case we moved to sort of coupon issuing or Gilts earlier in the Feds case they'll end up having to issue more more US Treasuries later because they're gonna get less income from the from the central bank. But the reason why it's been important recently in the UK is cases that the fiscal accounts are already fairly precarious. Post COVID And then obviously, we had the energy shock. And so that energy shot meant that it meant the Bank of England so the treasurer was gonna have to issue more guilts to pay for the the sort of household energy bills plus the was the fact that inflation was pretty high and the current account deficit was widening. So we're relying on non resident inflows to finance the external balance and on top of that, the Bank of England selling Gilts and on top of that they're requesting this indemnity. So requiring more insurance now, so it was all sort of that was a perfect storm of things that came together. But the since the arrangements are not necessary at this stage, it's not at all clear why why we're adding this extra fuel on the fire of the of the fiscal accounts in the UK when actually it can be dealt with over time, as in the case of the US Fed. So, you know, that's, that's the way that I kind of think about this. But of course, I was gonna say there's the additional angle here, of course, is this becoming more political now? This is where the Bank of England this is what may be most dangerous thing about the Indemnity now is the fact that, as you've noted, it's already been in various newspapers not yet The Sun, but I'm sure it will be. And so this kind of makes either the Bank of England look bad or casts the public finances in a bad state, because macro policymakers have taken these measures to support the economy, but actually, it's kind of backfired. And if that makes the Bank of England more reluctant, so there are two problems here. The first one is that in the future, if it becomes so politically hot topic, then if the Bank of England needs to do more QE in the future, and it goes to the Treasury and says, Would you mind giving us the indemnity which they did during the mini mini mini crisis after the mini budget, sorry, in October, if they do that, and the Treasury says, No, it's too embarrassing. If you make losses, then what's the Bank of England going to do? Well, presumably if they believe their financial stability mandate, or they take that seriously, they'll just have to find a way around it, which is to say, just do it without the Indemnity. And then in any case, it may make the Bank of England more reluctant to do QE in the future, which, depending on what your viewpoint is maybe a good or a bad thing, but I think the fact that this may weigh on their decision making in the future is not a good, good thing. So in a way, we're in this situation. Now, I think we're because it's become such an important topic. It makes future it may be constrained future policy in a way that is not going to happen elsewhere. I think that's probably the worst legacy of this situation.
Meyrick Chapman
Yeah. Yeah. I agree with I agree with that. I think this is an as an aspect of something you've been discussing with me, which I'd like to come back to which is the use of balance sheet in future and how it how it, how it may have that discussion hasn't really emerged either. But but but before we get to that, there are a couple of points which I'd like to make. First of all, what we're talking about now in terms of losses from QE or losses, via QT, that losses on their balance sheet. Is is almost impossible to determine whether those losses which are evident, but whether there is actually a cumulative loss to the consolidated government balance sheet, it's almost impossible. I would say it is impossible to determine whether QE has actually helped the government finances or not, including the losses and so this is a counterfactual of what what would have happened if QE had not been initiated, isn't is it is a counterfactual, we'll never going to find out. But I think there is a plausible argument that central banks were obliged to intervene at some point in the last decade to support the financial stability mandate, as you call it, to stop the system falling down. The question the question is whether it was appropriate at every instance, in the last decade, and I think it's pretty clear with hindsight that it wasn't necessary in 2020 2021, at least not to the extent that it was exercised, but we'll never know whether these losses could could be justified. But what we do know is the losses will fall on the taxpayer. We don't quite know where the benefits have fallen, although we can make some pretty educated guesses looking at the performance of stock markets and asset prices over the last 12 months over the last 12 years that the QE have been has been in operation. And there's another another point, I think, also which does worry me, which is the Federal Reserve is has is by far the most open in its plans for and projections for how to deal with losses. Through the creation of the deferred asset on its portfolio and plans I said, have existed probably for about 10 years in some form. And there are quite a few papers that project the interest income and interest expense associated with their portfolio. And there's a pretty clear plan in those papers that remittances to the Treasury are going to cease for a number of years. They suggest three, I would suggest it might be longer than three. And those during that time, they will first of all build up a deferred asset and then it will be paid down through seigniorage but the characterization of the the portfolio, excuse me, the characterization of the balance sheet of the central bank, during that period is quite interesting. It suggests that the way that the Federal Reserve will pay for these losses is by resuming purchases of coupon bearing instruments on its asset side. Meantime, on the liability side, it will increase the amount of currency and non interest bearing liabilities on the liability side. What this means is yes there should be a reduction of interest bearing liabilities, namely reserves, but that the balance sheet of the Federal Reserve will remain extremely high relative to historical standards. I mean, it looks to me as if it's going to plateau out for the long term above 20% of GDP. So that's, that's massive compared to where we were before the financial crisis. So even under the relatively well developed plans. There is an assumption that the central bank is going to remain very, very involved in the economy of the US. Given that we haven't got any really clear plans from other central banks, I think we can take the thoughts of the Federal Reserve as kind of a template for what others are going to have to be thinking about. Because it's, it looks as if the reason for this very large balance sheet is it's a it's a it's a consequence of trying to deal with the losses that there is there's no particular reason why the balance sheet should grow except that they need the extra coupon income. So I think that's, that's not well discussed. I think the other issue which goes back to financial stability, in a sense is that there have been numerous papers and studies by the Federal Reserve, on what the minimum level of reserves in the system is to maintain control of short term interest rates, which as you pointed out earlier, is is has now returned as the primary policy tool. Well, some of the most detailed studies suggests that the level of reserves in the system in the US would need to be something in excess of 13% of GDP, or equivalent to 3.4 trillion at more or less current levels. Well, that the plans that have been published for the reduction of the Feds deferred asset, require reserves and overnight reverse repo reserves generally, in one form or another, to fall well below that level. So I think there's there's a potential tension here between trying to avoid losses and trying to maintain financial stability because these people papers argue that short term interest rates will need a very high level of reserves in future to to maintain the relationship between in the US between Fed funds and and the interest on reserves. So in other words, for the for the central bank to maintain control of of interest rates. I think that that particular tension hasn't emerged anywhere else. I don't think it's emerged yet in the Fed, but it's clearly there in the studies which they've done.
Chris Marsh
Yeah, it's interesting, I know you mean they are more advanced in explaining explaining how how their balance sheet is going to evolve in the future. And you know, when we look at the Bank of England all we have really the sort of the admission that bank balance sheet will be smaller than it was recently, but largely, it was pre GFC. But they're never clear on exactly where we're going to settle. I think their attitude is Well, we'll find out when we get there, because banks will will demand the reserves and they will provide them at that time. So the Bank of England pretty vague on that point, but I think what you're outlining in terms of the Fed is also an interesting question, because, you know, there may be circumstances where losses become problematic for central banks. So you're gonna have to look at some of the more extreme cases in emerging markets and frontier markets have central bank balance sheets gone wrong, where they end up having to monetize everything and and that impacts inflation and living standards and so forth. So, is clearly a case where it can be it can be problematic, but in in the case of developed markets with with very little loss of foreign currency, liability denominated debt it shouldn't be a major issue. The main concern is making sure they hit your inflation target. When when we think about the Feds situation at the moment, though, what's interesting is that when they because they are reinvesting some of the assets that they're, that they're they're sort of maturing, and as you point out, they think at some point their balance sheet is going to settle into some representative GDP. So they're going to have to buy assets and, and where on the on the sort of on the, on the Treasury curve. They're buying those assets, what yield they're gonna get, what coupon they'll pick up will determine what the sort of monetary income will be and how fast they run down the deferred asset. And there is a scenario where because at the moment, the yield curve is, is very inverted, you know, if they're sort of investing in long term treasuries, but they're still paying a higher interest on their reserves, then in fact that monetary income doesn't materialize for a while as this goes back to the point you're making so it's not clear when they're actually going to be able to start running down the deferred asset. But it could be that the current projections end up being wrong and the economy is in a very different place to what anyone could have imagined a few years ago. And we do have to wonder how long this can go on. Now, this is not to say that I don't that because I do like the way the Fed is dealing with this but I do think there are some nuances about how this will play out in terms of how you know that their balance sheet. For the Fed, it really doesn't matter and I think it is the same for the Bank of England, but these are conversations that should happen, right? We need to think about.
Meyrick Chapman
I think the surprising thing for me and I think for you is that so far, the discussion has been really absent, particularly as far as the Bank of England is concerned, or I should say, particularly in public as far as the Bank of England is concerned. I mean, who knows what they're talking about behind closed doors, but we're not getting any indication of the seriousness of, of the issues that we think should be out there in the public and being debated. I think there's another angle which I'd like to ask you about Chris, which is you know, how, how the Bank of England may treat its balance sheet in rundown with regard to policy, this is I know, this is something which you've thought about and in particular, with regard to the monetary overhang since the pandemic, that there might actually be a policy benefit in, in in the configuration of the balance sheet.
Chris Marsh
Yeah, exactly. I think this is this fits into the area of what we just don't know, but it's not being talked about. So what what's what's happening across the world is the different central banks of setting different QT plans according to what they think is the right the pace given this sort of, you know, their maturity hold the holdings of assets, the maturity and so forth. And, but one question that ought to be at least considered is whether this the speed at which Qt happens is an additional important contribute contribute contributor to the overall policy stance. So we mentioned earlier that the bank strategy is what we use Bank Rate, and now we're tightening and we think QT can happen in the background and its impact on on on the overall policy stance is marginal. But, but what but what that does, is that downplays the overall structure of private sector balance sheets, and the size and the structure of balance sheets. So what's different this time about QE in the pandemic is that the QE was associated with the government deficits basically. So it was associated with an improvement in private sector and net wealth. And that showed up in monetary wealth because roughly speaking that the the the central bank monetize the fiscal deficit, and that ended up as deposits with the banking system. So to put this in concrete terms in the UK, the money and currency and deposits held by households at the end of 2019 was 1.7 trillion pounds. Two years later, that was 2 trillion pounds. So 300 billion increase in in household holdings of currency deposits in two years. That is three times the size of the increase over the previous two years. So this is sort of like this excess this if you like this excess savings, as people call it another surplus of claims on the banking system, because of the conduct of policy, the combination of fiscal and monetary policy. And in the context of contracting the balance sheet question is worth asking whether the pace of QT, allows that balance sheet structure this relative claims on on money and other assets to change quicker than or more quickly or less quickly, depending on how you want to see that structure evolve and why it matters. And the reason why it matters is a couple of reasons. One is and I think in the United States context, the the blog of FedGuy, Joseph Wang, I think his name is he's he's pointed out look, the interest rates on deposits by the banks that passing on are still very low. They're not passing on Fed funds rate, the increase in policy. It's the same in the UK, I checked yesterday, the deposit rates in the UK are no higher than they were in 2017, despite the bank rate being much higher. So the policy tightening is feeding through very, very slowly into the bank deposit. And if that if that therefore encourages or discourages people from saving, and so that the money gets passed on more quickly. So you kind of go into a large velocity of that of that money within the the economy and particularly within financial assets. So basically, it's bidding up stocks and other financial assets still, then it could be impacting over the overall strategy of monetary policy. And the other reason why may be important, or the reason why the banks not passing on the interest rate as quickly as they might because they're quite happy to see deposits run off. It's not really it's not very profitable for them to to hold these deposits, perhaps in which case you've got a situation where the banks are not passing on the the increase in policy rate. And if that's the case, then again, it's not really been transferred to the housing sector to the people who need to benefit from that which might therefore be impacting the overall spending situation. Now, I don't think I have the answer to this, but I do know that nobody's really talking about this. How to manage it if you like the monetary overhang. And it seems odd that we're not having a conversation.
Meyrick Chapman
Yeah, it does. It these are very large numbers, which we're talking about. And it's it's the balance the household balance. household wealth is so so extremely elevated. And I think this also at least has some bearing on something which I've been looking at recently, which is the actual monetary overhang from from the pandemic still remains high in at least in the major economies that I've looked at, which is the US and Europe. That still is has to has to be worked through. So against a background of still elevated inflation. If you have effectively I think you what you're identifying through these very high levels of deposits and household wholesale household wealth is really at the effect of the monetary overhang that that's still still there after the pandemic policies. So it has an it has a potentially inflationary effect as well.
Chris Marsh
Yeah, exactly. I think that's the interesting thing about the this monetary shock we just had, it kind of underlines the importance of some of the writings of the monetarist thinkers if you like in the in the 50s and 60s and maybe in the 70s, one of which was to recognize that transmission mechanism from a monetary expansion is much richer than sort of some of the descriptions you get in a textbook and their transmission mechanism, says Friedman, was that, you know, a monetary expansion by the way, he was pretty vague about whether it was just Base money or broad money that was expanding. I think broad money is the key here. broad money being household deposits and therefore, sort of contribution to their net wealth. And if and a monetary expansion he pointed out Friedman that is will impact would impact for example, durable goods well, so he would go through asset prices, other asset prices so bonds and equities, would impact housing, housing, real estate, it would impact consumer durable goods, and then slowly impact other prices. And what we've kind of seen from the pandemic is that is that tiering of impacts on equities and government, securities and obviously cryptocurrency was first impacted. So the monetary expansion fed into asset prices and then obviously durable goods was the first thing to show in the consumer price indices across the world and some various non energy industrial goods as it's called. And then now we're having now it's impacting services and obviously wages come coming towards the end. So there's a hierarchy of different types of, of, of either asset or product. And it's feeding through those and we're, you know, how far are we into this, this adjustment to the monetary overhang? One simple way to judge this is in the United States, the expansion in money was about 40%. And we've had about 20% inflation. So if you're a true believer in some sense of neutrality, then we're only kind of halfway through. I think that may be exaggerated because other things will move that will allow this to allow this to come to an end at some point, but it's no reason why the inflation can't remain relatively strong, even if it's lower than the peaks for still another year or two. So, you know, it is interesting to think about the balance sheets and the role of money and balance sheets and and how this feeds into different asset prices and into inflation. And, you know, again, it's something that kind of the modern monetary thinking doesn't really allow it. Allow us to think about these issues.
Meyrick Chapman
Yeah, I think that's a mantra you and I have, both privately and often publicly said that this needs to be to be thought of thought of a great deal more by by the central bankers. And I'm sure it will be. Chris, this has been fascinating, and it's just the beginning. I think of this discussion in public. I know you and I will be talking about this a great deal more together. And hopefully, we'll get some of our own ideas out into the greater public. So thank you. Thank you for joining me. It's been it's been interesting, and it's been fun.
Chris Marsh
Thank you, Meyrick. Thanks for having me on. Thank you
Exorbitant Chat, Episode 4: Chris Marsh