The idea advanced by the New Economics Foundation think tank is deceptively simple. Rising official rates mean the Bank of England will start paying more interest on the billions in additional bank reserves created to buy government bonds under its quantitative easing programs. The NEF and others question why taxpayers’ money should be spent to give banks a fair return on excess cash that appears to have been sitting idle. After all, Chancellor of the Exchequer Rishi Sunak is seeking funds to help people deal with a growing cost of living crisis.
Unfortunately, it is not so simple that bonus-hungry bankers receive profits for no reason. The proposal is based on achieving fiscal savings by changing the way the central bank manages Britain’s borrowing costs. But these changes have no obvious benefit for monetary policy, while there is a risk of disrupting the influence of official interest rates on the economy. There are also big misconceptions behind what payments to banks represent. And it’s not just a British story: it illustrates how political and financial complexities befall each central bank as they unfold 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 suffer losses from higher payments on reserves once the BOE rate will reach around 2%. But the story is really how and when Britain pays its public debt.
First, a quick refresher on QE: the BOE has created hundreds of billions of pounds of reserves, money only available to banks, to buy bonds in the market, either from the banks themselves , or from other investors via 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, that rate was well below 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 program, of which £120 billion was returned to the government. While that might look like a profit if the BOE were a fund manager, it’s really just savings on the cost of servicing outstanding UK debt. The government and its central bank are just different branches of the state; these savings allowed government spending to be higher or taxes and borrowing to be lower than if government bonds had remained in private hands.
Government bond coupons do not change until the debt is refinanced, but interest on reserves increases with the rate set by the BOE. When this reaches 2%, payments on these reserves will exceed the total coupons received on BOE bonds. The government will have to start paying back some of the £120 billion in savings to date, but it may never pay them all back. A recent analysis by the BOE estimated that QE could result in public savings of around £40 billion by the time it is phased out completely 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 graduated rates. Tiering was introduced in Europe to shield banks from some of the pain of negative rates. If you can help the banks in this way, why not limit their profits in the UK situation? It may sound tempting, but there is never a free lunch. Money markets and central bank interest rate transmission is a complex system that can react unpredictably to tinkering, even when changes have been well telegraphed.
While the cost of interest on reserves is expected to rise rapidly, if the BOE gets inflation under control, it could also come down quickly. The UK will still have to refinance government bonds at high yields, paying higher coupons than exist today. These interest charges will persist for years. The difference really comes down to the timing and persistence of UK public debt costs. One way or another, the interest on the reserves will not remain higher than the coupons on government bonds forever.
Also, central banks started paying interest on reserves for a reason. Quantitative easing has left banks drowning in excess cash and if they earn nothing, they will compete to lend it to other banks or exchange it for government bonds or safe treasury notes at short term. This would drive short-term market interest rates below the level set by the central bank, thereby undermining monetary policy. Policymakers might find other ways to mop up that excess cash, but there will be some sort of cost somewhere.
The BOE could tell banks that they must hold a very large portion of reserves as central bank deposits while paying no interest on them. But because these reserves are in fact the current method of funding much of Britain’s debt – bonds held in QE are equivalent to nearly 40% of government borrowing – not paying interest on these s akin to free government borrowing, a form of monetary financing that is generally frowned upon, not least because it risks fueling inflation.
If QE didn’t exist, all UK government bonds would be in the hands of the banks (and insurers, pension funds, foreign investors and other central banks) and Britain would probably have already paid a lot more for its debt. The government must find ways to sustain public spending and tackle the cost of living crisis. It would be good to think he has made good use of the £120billion savings he has enjoyed so far.
The language of the NEF and others pushes the idea that the banks are going to get a big boost in taxpayer profits for doing nothing. What’s really going on is juggling how and when Britain pays its public debt – alongside the regular operation of trying to ensure the economy tracks BOE interest rates . Ostensibly easy savings through tinkering with the system might turn out to be more trouble than it’s worth.
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Paul J. Davies is a Bloomberg Opinion columnist covering banking and finance. Previously, he was a reporter for the Wall Street Journal and the Financial Times.
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