Speech by BoE's Catherine L Mann at the Federal Reserve Board of Governors
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Quantitative Tightening and Monetary Policy Stance Speech by
Catherine L. Mann, Prepared for the IF 75th Anniversary Conference,
Washington DC, 2 June 2025 Introduction Central banks in advanced
economies are currently navigating three simultaneous challenges:
the pace and potential endpoint of the rate-cutting cycle, the
extent and strategy for normalising the balance sheet, and the
implementation of new institutional frameworks for reserves
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Quantitative Tightening
and Monetary Policy Stance Introduction Central banks in advanced economies are currently navigating three simultaneous challenges: the pace and potential endpoint of the rate-cutting cycle, the extent and strategy for normalising the balance sheet, and the implementation of new institutional frameworks for reserves management and policy rate control. Different countries are approaching these areas at varying speeds and with differing institutional designs. In previous speeches, I have discussed the rate-cutting cycle. Today, I will focus on how balance sheet normalisation and the institutional framework under development at the Bank of England affect my monetary policy decisions. I'll begin with a monetary policy perspective on the balance sheet, outline the new approach being implemented at the Bank, and then pose some open questions about how this institutional transition might influence policy-making. A Monetary Policy Perspective on the Balance Sheet and Transmission Monetary policy and financial stability considerations guide thinking about the optimal steady-state balance sheet. According to the Bank of England's Principles of Engagement, the Monetary Policy Committee (MPC) holds marginal authority over instruments and facilities deployed primarily to affect overall monetary conditions and maintain price stability. The MPC also approves schemes and structures designed to achieve this objective. In normal times, Bank Rate—the interest rate on reserves—is the MPC's main policy tool. It determines SONIA, which anchors the short end of the yield curve and serves as a reference rate across financial markets. Maintaining short-term market interest rates close to Bank Rate is vital for effective policy transmission. Before the global financial crisis (GFC), short-term money markets distributed and intermediated Bank Rate, supporting liquidity. But these markets froze during the GFC due to counterparty risk and liquidity hoarding. Quantitative Easing (QE) was introduced to complement Bank Rate, easing financial conditions when rates hit the effective lower bound. QE focused on purchasing long-dated government bonds, reducing long-term yields and flattening the curve. Research indicates that medium to long-term gilt yields dropped by about 100 basis points in response to the first £200 billion QE programme. Later QE announcements had diminishing effects. The yield curve steepened after the GFC but flattened during the decade following, due in part to QE and international factors. More recently, the curve has steepened again, especially at the long end. The Bank purchased around £875 billion of UK government bonds across five QE rounds between 2009 and 2021, significantly expanding its balance sheet. Active or passive run-off reduces the risk of a ratchet effect in balance sheet size and increases headroom for future policy actions. In September 2022, amid inflationary pressures caused by Russia's invasion of Ukraine, the MPC initiated gilt reductions through passive and active strategies. Balance Sheet and New Institutional Design QE required a large reserve expansion, creating an abundant (supply-driven) reserves system. In such a system, excess reserves eliminate the need for institutions to borrow above Bank Rate. With reserves remunerated at Bank Rate, there's little incentive to lend them below it. Market competition ensures overnight rates stay close to Bank Rate. Theoretical models help compare “scarce” versus “abundant” reserves regimes. In a scarce system, short-term interest rates reflect the cost-benefit of holding reserves versus investing. Active management is required, which can be costly and challenging. In an abundant system, reserve demand becomes flat beyond a certain point, meaning shocks have little impact on interest rates or quantities. QE moved us into this zone of abundance. As Quantitative Tightening (QT) progresses, reserves may return to scarcity. This marks a transition to a demand-driven regime, where interest rate control relies on liquidity availability via repo facilities. The Bank's short-term repo (STR) facility, offered weekly and priced at Bank Rate, helps anchor seven-day rates. The indexed long-term repo (ILTR) facility offers six-month borrowing with broader collateral eligibility and price indexing to Bank Rate. In stylised models, STR is a flat supply curve above Bank Rate due to collateral haircuts. Under abundant reserves, uptake is low. But as reserves decline, banks are expected to use these facilities more. This system insulates rates from temporary shocks but shifts the effect of liquidity demand from prices to quantities. While this supports rate control, it reduces the informativeness of market rates. Repo market spreads may become more relevant for detecting stress and guiding policy. Empirical Indicators and Evidence SONIA's relationship to Bank Rate can indicate reserve system status. When reserves are scarce, SONIA rises above Bank Rate; when abundant, it stays slightly below. As reserves decline, SONIA has edged upward, suggesting tightening conditions and aligning with increased repo facility use. Bank researchers, building on work by Lopez-Salido and others, have estimated a time-varying demand curve slope for reserves. The model shows reserves became inelastic after exceeding 16% of nominal GDP in 2014. Recent data now suggest a mildly negative slope, indicating a return toward scarcity. This transition could bring volatility in reserve demand and complicate real-time estimation. Survey-based reserve demand estimates vary widely (£385–530 billion), underscoring uncertainty. The wedge between SONIA and Bank Rate can inform policy decisions, though its interpretation must consider both macro signals and credit-specific factors. Monetary Policy Implications and Open Questions Balance sheet normalisation raises several policy questions:
QT differs from QE and is not its mirror image. QT is intended to run in the background, gradually and predictably. It doesn't signal future policy, but it may still influence financial conditions. For example, Bank staff estimate that an £80 billion QT programme could raise 10-year yields by 20 basis points—equivalent to the impact of a quarter-point Bank Rate hike. QT adds duration back into the market, potentially steepening the yield curve. Cutting Bank Rate cannot fully offset this tightening because it affects different parts of the curve. This asymmetry is critical to understanding monetary policy transmission. Research shows that changes in the yield curve slope matter more for macroeconomic outcomes than level shifts. UK-based studies support findings from the euro area: yield curve steepening tends to be contractionary, lowering inflation and output. Conclusion As the MPC prepares for its next QT decision in September 2025, market expectations point to a £75 billion reduction in gilt holdings. The key issue is not the balance sheet's absolute size but its normalisation strategy and its effect on monetary conditions. If large enough, asset run-off and sales may influence the policy stance and must be factored into rate decisions. Efforts to offset QT with Bank Rate cuts may not be equivalent. QT steepens the curve, while Bank Rate targets the short end. Moreover, a premature or excessive cut could undermine efforts to keep policy restrictive long enough to address structural rigidities. These complexities will undoubtedly shape MPC discussions in the coming months. |