The idea proposed by the New Economics Foundation think tank is deceptively simple. The rise in official rates means the Bank of England will start paying more interest on the billions of extra bank reserves created to buy government bonds in its quantitative easing programs. The NEF and others question why taxpayers’ money should be spent on giving banks a good return on extra money that appears to have been left to do nothing. After all, Finance Minister Rishi Sunak is looking for funds to help people cope with the growing cost of living crisis.
Unfortunately, it’s not as simple as bonus-hungry bankers taking profits for no reason. The proposal is based on making fiscal savings by changing the way the central bank directs Britain’s borrowing costs. But there is no obvious benefit to monetary policy from such changes, while there is a risk of altering the way official interest rates influence the economy. There are also big misconceptions behind what payments to banks represent. And it’s not just a UK story – it illustrates how political and financial complexities are coming to all central banks as they unwind years of quantitative easing.
The Office for Budget Responsibility, a public spending watchdog, the NEF and others say QE has been profitable in the past, but will start to take a loss due to higher reserve payments once the BOE rate hits. to about 2%. But the story is really about how and when Britain pays off its public debt.
First, a quick update on QE: the BOE created hundreds of billions of pounds of reserves, money only available to banks, to buy bonds from the market, either from the banks themselves or from other investors through their bank accounts. . Like the Federal Reserve and many other central banks, the BOE pays interest on excess reserves deposited with it by commercial banks at the interest rate it sets for the UK economy as a whole.
For years this rate was far less than the coupon payments the BOE received on the government bonds it holds, which currently total around £850bn. This meant huge positive cash flows accumulated in the QE programme, of which £120bn has been returned to the government. While this might seem like a gain if the BOE were a fund manager, it’s really just a saving on the cost of servicing Britain’s outstanding debt. The government and its central bank are simply different arms of the state; These savings have allowed government spending to be higher or taxes and borrowing to be lower than if government bonds had remained in private hands.
The government bond coupons do not change until the debt is refinanced, but the interest on the reserves increases with the rate established by the BOE. When it hits 2%, payments from those reserves will exceed the total coupons received on BOE bond holdings. The government will have to start paying back some of the £120bn of savings made to date, but it may never pay back all of it. A recent BOE analysis estimated that QE could result in public savings of around £40bn when fully wound down around 2070.
The NEF and others argue that the BOE could stop paying interest on reserves, or at least a large part of them, by introducing tiered rates. Layering was introduced in Europe to shield banks from some of the pain of negative rates. If you can help the banks in that way, why not limit your profits in the UK situation? That may sound tempting, but there is never a free lunch. Money markets and the transmission of central bank interest rates are a complex system that can react unpredictably to adjustments, even when the changes have been well communicated.
While the cost of interest on reserves will rise rapidly, if the BOE controls inflation, it could also fall rapidly again. The UK will still have to refinance high-yielding government bonds, paying higher coupons than exist today. Those interest costs will persist for years. The difference really lies in the timing and persistence of UK government debt costs. One way or another, interest on reserves will not remain higher than government bond coupons forever.
Also, central banks started paying interest on reserves for a reason. QE has left banks drowning in excess cash and if they make nothing of it, they will compete to lend it to other banks, or to exchange it for safe short-term government bills or commercial paper. Doing so would drive short-term market interest rates below the level set by the central bank, undermining monetary policy. Policymakers could find other ways to soak up this excess liquidity, but there will be some kind of cost somewhere.
The BOE could tell banks that they must keep a large part of the reserves as deposits in the central bank without paying interest on them. But because these reserves are, in effect, the current method of financing a large part of UK debt (bonds held in QE equal almost 40% of public lending), paying no interest on them is akin to free state loans, a form of monetary financing that is normally frowned upon, especially since it risks fueling inflation.
If there were no QE, all UK government bonds would be in the hands of banks (and insurers, pension funds, foreign investors and other central banks) and Britain would probably already have been paying a lot more on its debt. The government needs to find ways to support public spending and combat the cost of living crisis. It would be nice to think that he has put to good use the £120bn savings enjoyed so far.
The language of the NEF and others pushes the idea that banks will get a big boost in taxpayer profits for doing nothing. What is really going on is juggling how and when Britain pays off its public debt, along with the constant operation of trying to ensure that the economy follows BOE interest rates. The seemingly easy savings of modifying the system could prove to be more trouble than they are worth.
More from Bloomberg’s opinion:
• UK discontent risks deepening unrest: Mohamed El-Erian
• Now is the summer of British rail discontent: Therese Raphael
• Are the UK real estate boom and bust days over?: Chris Hughes
This column does not necessarily reflect the opinion of the editorial board or of Bloomberg LP and its owners.
Paul J. Davies is a columnist for Bloomberg Opinion who covers banking and finance. Previously, he was a reporter for the Wall Street Journal and the Financial Times.
More stories like this are available at bloomberg.com/opinion