Economy · June 21, 2022

Cheap monetary policy? We reserve the judgment

Toby Nangle was previously Global Head of Asset Allocation at Columbia Threadneedle Investments. Tony Yates is a former economics professor and head of monetary policy strategy at the Bank of England.

The Bank of England’s rising interest bill has been in the spotlight in recent weeks. The BOE’s balance sheet has grown to nearly £ 900 billion after waves of quantitative easing. And while there were linked tax dividends to effectively reduce the rate structure – around £ 123bn as of the end of April – there could be tax costs as rates hike. So what do you do?

First, a brief summary of the mechanics.

After nearly 15 years, there is still no agreement on how QE works as a policy, but operationally it is simple. The BOE purchased approximately £ 875 billion of interest-bearing interest and some corporate bonds. He paid for these bills with new central bank reserves. As a result, the assets side of the Bank’s balance sheet grew (gilt!) As did the liabilities (reserves!).

Prior to QE, the BOE set overnight interest rates by regulating the amount of (unpaid) reserves in the market. Commercial banks would then rush to borrow or lend them to each other at a price, and that (market) price was the bank rate.

QE meant that large quantities of reserves were created, so fine-tuning the reserve quantities to the target price could no longer work. The bank had lost the ability to limit rates and recognized: a) financial institutions would have faced problems of such magnitude that negative rates could have been contracting rather than stimulating; and b) there may be some unpredictable adverse consequences of diving into the world of unmanaged negative interest rates. Paying interest on reserves was a way to keep rates in check, while doing huge amounts of QE.

And so QE led the Bank to receive coupons on the gilts it had purchased and to pay interest on reserves. The positive carry was, and continues to be, huge:

But now, with interest rates on the rise, interest costs linked to the passive side of book QE (interest on reserves) threaten to outstrip the asset side income of book QE (the gilts).

Will this cause the BOE to fail? Absolutely no! Aside from the fact that it is difficult for a central bank – which can literally imagine all the new money it wants to exist – to run out of credit, the bank was careful at the start of QE to ensure that the entire program was sponsored by His Majesty the Treasury. In return, the Treasury received all of this huge positive carryover.

But as described, it appears that taxpayers are grappling with the profits and losses of one of the largest long-running exchanges in history. At a time when yields are rising. And the net cash flow turns negative once the bank rate moves north by 2%.

Two UK think tanks, the National Institute of Economic and Social Research and the New Economics Foundation, have published plans to maintain this positive effect.

The NIESR plan is based on the insights of Bill Allen, a former head of the BoE’s market operations division and economic historian who wrote the UK’s definitive monetary history of the 1950s. At the start of the decade, Britain had 175% debt to GDP and by 1959 this had fallen to 112% despite modest growth and low inflation. How? Allen argues that the answer has been outright financial repression – direct control by monetary authorities over banks and credit – and that the lessons of November 1951 can be borrowed to financially crack down on banks today.

In particular, the NIESR argued last summer that banks should be mandatorily allocated for two newly created years applies to commercial banks at non-market prices in exchange for their reserves “as a means of draining liquid assets from the banking system and to to isolate public finances to some extent from the costs incurred in raising short-term interest rates, as in March 1952. ”Failure to comply with this plan, according to NIESR, cost the Treasury £ 11 billion.

The NEF plan, by contrast, follows Lord Turner’s suggestion to pay zero interest on a large block of commercial bank reserve balances, but to continue paying interest on the remaining marginal balances. This approach has international precedents: this is how things are done in the Eurozone and in Japan. NEF estimates that HM Treasury would save £ 57 billion over the next three years if their plan were adopted.

FREE money! Where’s the catch?

Well, the NIESR plan is. . . disconcerting. The authors admit that its implementation would lead to dizzying returns and could disrupt the government bond market in sufficiently unpredictable ways. They recommend that “a modest first step could test the magnitude of such an impact.”

In a world where a central bank forex trader asking for real-time price controls constitutes intervention, this “modest first step” could end. . . bad?

And any scheme that imposes an unplanned and fundamental reconfiguration of any commercial bank’s balance sheet would pose a number of financial stability issues. It is probably not an exaggeration to argue that the implementation of the plan may even have triggered a financial crisis. However, the plan would have resulted in banks’ income being £ 11bn lower and government income £ 11bn higher.

For all politicians reading this “yes, but ELEVEN BILLION !?” thought, a lower risk way to scratch the itch could be to introduce a £ 11 billion tax and perhaps not accidentally trigger a financial crisis.

The NEF plan, on the other hand, seems more reasonable. It is rooted in the practices that other large central banks have operated (albeit only during periods of negative interest rates).

But as Bill Allen (of the NIESR plan) writes, it could have negative consequences for the financial system and would shift QE from a monetary policy tool to a taxation tool. Furthermore, taxation would be continuous and indefinite, with commercial banks being more taxed than less regulated financial channels. Rising QE stock would push taxes on commercial banks higher; conducting QE would cut taxes on commercial banks. This overturns the traditional logic of balance sheet operations (where QE is more commonly associated with easing).

Some argue that we should tax banks more. Others argue that this would only raise costs across society, increase the risks of financial instability and hinder growth. If the Chancellor wanted to tax banks more, why not… er… tax banks? It is illogical to link this decision forever with the decision on how to implement the desired monetary policy stance.

That said, we see a good case for speeding up the Bank’s icy calendar for the dissolution of QE, or for auctioning off new sterilization bonds in the system – and returning to the reserve averaging system of yesteryear. Coincidentally, these reserves would not really require any remuneration.