Back to the future: With repos, not QE, is how central banks handled issues before 2008. The Fed also revived tools to go back into that direction.
By Wolf Richter for WOLF STREET.
“The Bank of England is not alone in facing these choices. Central banks around the world are grappling with similar questions as crisis-era asset purchase programs and funding schemes are withdrawn,” Bank of England Governor Andrew Bailey said towards the end of his lecture at the London School of Economics this week, after he had laid out:
How much more the BOE’s balance sheet might drop (a lot more).How it would get there (including through outright sales of bonds).How the BOE would continue shedding bonds even after the balance sheet is low enough and stays level, until all bonds are essentially gone.How repos would then provide liquidity as-needed to the banks.And how this would change the composition of the balance sheet from long-dated bonds to short-term repos.
The BOE’s outline of a plan harkens back to how it was before the Financial Crisis – before QE showed up. With repos was in essence how the BOE, the Fed, and other central banks had handled liquidity issues and market disfunctions for decades until the Financial Crisis in 2008.
And the BOE is now the first major central bank discussing how it plans to revert to a similar system as before, draining reserves, then using repos – instead of bond purchases (QE) – to deal with issues.
In general, central bank repos are short-term instruments by which the central bank lends cash to approved counterparties (such as banks) against approved collateral (such as government bonds). They mature the next day, or in a week, or in 30 days, etc. And when they mature, the central bank gets its cash back, and the counterparty gets its collateral back. If repos are not renewed, they come off the balance sheet automatically and don’t cling to the balance sheet for years or decades like longer-term bonds do.
The Fed has set itself up to be able to go into a similar direction when it revived the Standing Repo Facility (SRF) in July 2021 before it had even announced that it would pivot to QT. The Bernanke Fed had skuttled the SRF in 2009 because under the large-scale QE, the SRF wasn’t needed.
But under enough QT, the SRF was suddenly needed, as the Fed found out in 2019 when the repo market blew out because QT-1 had drained liquidity unevenly, and it wasn’t going fast enough where it was needed, and there was no SRF to deal with it, and instead the Fed ended up undoing part of QT-1 to calm the crisis. Now, with the SRF in place, the Fed is ready to deal with these situations, even as QT goes on.
The BOE’s bond holdings and QT.
During QE, the BOE lent funds to its off-balance-sheet entity, “Asset Purchase Facility,” which then purchased the bonds. What the BOE carries as asset on its balance sheet are these loans to the APF. Now, as QT is whittling down the assets in the APF, the APFis paying back those loans to the BOE, and they come off the balance sheet in those amounts.
The APF bought assets in four big waves: During the financial crisis (2009), the Euro Debt Crisis (2011-2012), Brexit (2016), and the pandemic (2020-2021). During the pandemic, the BOE added £440 billion, nearly doubling its bond holdings to £895 billion.
QT started in March 2022, when the first big bond issue matured and wasn’t replaced. In September 2022, when leveraged pension funds blew out and threw the market for UK government bonds (gilts) into turmoil, the BOE briefly bought gilts, that it then started selling in November; and three months later, it had sold them all.
The BOE is the only major central bank that has a policy of actually selling bonds, not just waiting for them to come off the balance sheet when they mature. Since November 2022, it has been selling bonds every week.
Under QT, the APF has dropped by £194 billion, or by 22%, from the peak, to £701 billion. In other words, the BOE has now shed 44% of its pandemic bond purchases, including all of its corporate bonds.
The BOE sells bonds outright.
At the peak of its holdings in February 2022, the BOE held about 55 gilt issues with varying maturities: Three issues matured in 2022, two in 2023, three in 2024, etc., all the way out to the year 2071. Obviously, waiting for these long-dated gilts to roll off when they mature would require a lot of patience. So the BOE has been selling bits and pieces of each issue week after week.
For example, one small issue, maturing in 2039, has already been sold off entirely. The issue maturing in 2071 has been sold down by one-third, to £10.2 billion currently, from £15.5 billion at the peak. The issue maturing in 2068 has been sold down to £8.9 billion, from £9.3 billion at the peak, etc.
The chart shows the maturity profile of the remaining bonds in the APF as they had been on two dates: in February 2022 (blue line) and now in May 2024 (red line).
The difference between the blue line and the red line reflects the bonds with maturity dates in the future that the BOE has already sold outright:
QT draws down reserves. How low can they go?
Reserves are cash that banks keep on deposit at the BOE. They’re the most liquid form of money with which banks settle transactions with each other. They are also essential for financial stability if banks need liquidity, or need to provide liquidity to the financial system, as Governor Bailey explained at the lecture.
QE ballooned the reserves. QT draws down reserves. And now it’s a question of how far they can be drawn down before the financial system runs short on liquidity, he said.
“Before the financial crisis, monetary policy was implemented with a much lower level of reserves than we have today. That worked well enough for monetary policy. But as we discovered to our cost, the level of liquid assets in the system, including central bank reserves, was too low for financial stability purposes, and this contributed to the scale of the financial crisis,” he said.
“Equally, at some point the costs of an increase in reserve supply are likely to outweigh the benefits. Generally speaking, as reserves levels grow, the incentives for the banking sector to manage its own liquidity fall. And to the extent that reserve supply crowds out healthy market intermediation in normal market conditions, a large part of the financial system’s ability to manage its liquidity will be affected. Mindful of these costs, we do not seek a larger balance sheet than is strictly necessary,” he said.
And this is where the concept of “Preferred Minimum Range of Reserves” (PMRR) comes in. It’s “an estimated range for the minimum level of reserves that satisfies commercial banks’ aggregate demand, both to settle their everyday transactions and to hold cash as a precaution against potential outflows in times of stress,” he said.
Except the PMRR “cannot be objectively observed,” “is likely to evolve over time,” and will be affected by a number of factors, that he listed.
Reserves are down to £760 billion. The latest assessments for the PMRR are in the range of £345 billion to £490 billion. So the balance sheet could drop by an additional £270 billion to £415 billion. At the current pace of QT, and the unwinding of the pandemic-era “Term Funding Scheme for Small and Medium-sized Enterprises” (TFSME), reserves might fall into the £345-490-billion range at the earliest in the second half of 2025.
Repos will deal with the “bumps in the road” on the way.
“But as we approach the minimum level of reserves demanded by banks, things get a little more complicated. We cannot be sure exactly where it is, and as we approach it, we may face a few bumps in the road with temporary frictions in money markets as firms adjusts to the falling supply of central bank reserves,” he said.
To deal with these frictions, the BOE established its a weekly Short-Term Repo (STR) facility in 2022, “complementing our other reserve supply operations – including our Indexed Long-Term Repo, or ILTR, which supplies reserves for six-months at a price related to demand, against a wide range of collateral,” he said.
“The STR allows banks to borrow unlimited amounts of reserves, against gilt collateral, at Bank Rate,” he said.
“In combination, these facilities will allow the unwind of QE and the TFSME to continue without the risk of any loss of monetary control on the way to the PMRR,” he said.
The “new phase” of QT after the balance sheet levels out.
“As this QT process progresses, the gilts held in the APF may eventually fall below the PMRR. Lending through the STR in the first instance, and eventually alongside our other facilities, will start to pick up the shortfall in reserves supply, to meet prudential needs for reserves and maintain monetary control through the setting of Bank Rate,” he said.
At that point, “the QT process enters a new phase,” he said. As QT (shedding bonds) continues, with the APF unwinding, while reserves remain steady at much lower levels, it will change the mix of assets from bonds to repos.
He defines QE as asset purchases; and QT as shedding those assets; while repos are short-term loans secured by collateral, and are not QE, and don’t have the effect of QE.
“For much of the Bank’s history we have lent on a secured basis, primarily against government securities and trade bills. Perhaps it is time to return to such an approach,” he said.
Handing interest rate risk (and losses) back to the financial sector.
Repos replacing gilts also eliminates interest rate risk for BOE. It has lost billions as gilt prices plunged when yields rose over the past two years. It loaded up on interest rate risk during QE by purchasing longer-term gilts.
QE “removed interest rate risk from the private sector and transferred it to the central bank balance sheet,” he said.
“QT is now reversing this process and unwinding the interest rate risk held by the central bank,” he said.
“While we will meet the demand for reserves, it does not mean that we should retain the interest rate risk,” he said, which is another reason to shed its longer-term gilts entirely.
But the transition from gilts to repos will take a while, as the remaining £701 billion of gilts in the APF “will take time to unwind,” he said.
So “we would expect a significant increase in our repo operations as we look ahead to the future, and the market should continue to ready itself for this,” he said.
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