21 May 2009

The DMO and the money merry-go-round

See also: my earlier post on our exclusive interview with Debt Management Office chief Robert Stheeman.

Here’s a remarkable fact. The Debt Management Office needs to raise £220bn this year. To do that, the DMO will sell £220bn worth of gilts into the market.

Meanwhile at the Bank of England they are in the middle of buying up to £125bn of gilts from the same market. Indirectly, the Bank is effectively funding between half and two thirds of the government requirement with its magic funny money.

Now that’s not the aim of the Bank of England’s programme of quantitative easing (a kind of supercharged interest rate cut), but it is the ultimate effect. 

In practice it means that in the morning the DMO holds auctions to sell billions of pounds of British government debt, and in the afternoon, just around the corner, the Bank of England holds an auction to buy billions of pounds of government debt.

Now if all this sounds a bit like a free lunch, I have put this bizarre money merry-go-round to both Mervyn King and DMO chief Robert Stheeman in recent days.

Mr Stheeman told me this:

“I fully admit it does look slightly strange… on the other hand, we must make the distinction – we are raising money by selling new gilts but the Bank is buying in the secondary market, outstanding old gilts.

“That market mechanism is fundamental – we couldn’t finance ourselves directly by the Bank, because that would be against the Maastricht criteria article 101. The market is the mechanism that determines the price – us selling, the Bank and others buying,” he says.

Mervyn King said this at a press conference last week:

“I think it would be only sensible, commonsense that we would consult with the Debt Management Office before we suddenly decided to dump a lot of gilts onto the market. This is something we want to – the timing of it – we want to co-ordinate with the Debt Management Office.

“But the decision about the scope of the sales and the broad timing is solely for the Monetary Policy Committee, it’s a monetary policy judgement. But we will liaise
with the DMO on that.”

Stheeman did admit that the Bank’s actions are lowering the government’s cost of funding, saying “it’s certainly conceivable that what they are doing has an influence on the price of debt,” but that this is normal, because the Bank of England’s decisions on short-term interest rates also influence the rice of government debt.

The really important thing here is the unwind. As things stand when the Bank of England decides the economy is recovering and that QE needs to be unwound, it might be dumping UK government debt on the markets at the same time as the DMO. This could turn into a nightmare.

Stheeman told me:

“It’s certainly possible that they [the BoE] might want to at the same time we have to sell gilts, but the Bank has been clear and the government has been explicit. They will be liaising with ourselves and the Treasury because we share a joint interest not to undermine the stability of the market.

“We don’t have contact with the Monetary Policy Committee, but I speculate that selling gilts may not be the first thing they would want to do, they may look to other instruments and I think the governor hinted at that in his inflation report.”

Basically we are in a remarkably sensitive time in the institutional structure that has driven the British economy.

The Channel 4 News video report from the Debt Management Office:

For this complex escape act to work, the Bank of England has to be seen to be motivated only to do things that will help keep inflation at 2 per cent. But my sense is that the Bank will not actually sell the gilts they are buying in such huge quantities.

Instead they will try some sort of short-term neutralisation policy to unwind quantitative easing, perhaps issuing controlled short-term debt instruments.

All of which is testing the boundaries between monetary and fiscal policy. And will create a complex web to be disentangled by anyone planning to be Chancellor.