Monetary policy on the cheap? Let’s reserve judgement
Toby Nangle was previously Global Head of Asset Allocation at Columbia Threadneedle Investments. Tony Yates is a former professor of economics and head of monetary policy strategy at the Bank of England.
The Bank of England’s rising interest bill has attracted increasing attention in recent weeks. The BOE balance sheet has swelled to nearly £900 billion after waves of quantitative easing. And while there were tax dividends associated with effectively shortening the rate structure – about £123 billion Until the end of April — there may be tax costs if rates increase. So what to do?
First a brief summary of the mechanics.
Nearly 15 years later, there is still no agreement on how QE works as a policy, but operationally it is simple. The BOE bought around £875 billion in interest-bearing gilts as well as some corporate bonds. It paid for these gilts with new central bank reserves. As such, the assets side of the Bank’s balance sheet (gilded!) rose as did the liabilities (reserves!).
Prior to QE, the BOE set overnight rates by fine-tuning the amount of (unpaid) reserves in the market. Commercial banks would then rush to lend or lend them at a price, and that (market) price was Bank Rate.
QE meant that huge amounts of reserves were being created, so matching the reserve amounts to the target price could no longer work. The Bank had lost its ability to floor rates and acknowledged: a) financial institutions would face problems of such magnitude that negative rates can be contractual instead of stimulating; and b) there could be some unpredictable ill effects from 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 they bought and pay interest on the reserves. The positive carry was and remains huge:
But with interest rates rising, interest costs associated with the liabilities side of the QE book (interest on reserves) threaten to exceed income from the asset side of the QE book (the gilts).
Will this put the BOE out of business? Absolutely not! Aside from the fact that it’s difficult for a central bank — which can literally imagine as much new money as it wants — to run without its own claims, at the outset of QE the Bank was careful to ensure that the entire program was reimbursed by HM Treasury. In return, the Treasury received all that enormous bear positive.
But as far as described, it sounds like taxpayers are on the hook for the profit and loss statement of one of the largest long-term transactions in history. At a time when revenues are rising. And the net cash flow turns negative once the bank interest rate moves north of 2 percent.
Two British think tanks, the National Institute of Economic and Social Research and The New Economics Foundation, have published plans to maintain that positive scope.
The NISR subscription is based on the insights of Bill Allen, a former head of the BoE market operations division and economic historian who wrote the definitive British monetary history of the 1950s. At the start of the decade, Britain had a debt-to-GDP ratio of 175 percent and by 1959 this had fallen to 112 percent, despite modest growth and low inflation. How? Allen argues that outright financial repression—the monetary authorities’ direct control over banks and credit—was the answer, and that the lessons of November 1951 can be learned to financially suppress today’s banks.
In particular NIESR quarrel last summer that banks must be required to allocate newly created two-year Treasury bonds to commercial banks at non-market prices in exchange for their reserves “as a means of withdrawing liquidity from the banking system and of isolating government finances to some extent from the costs incurred when the short-term interest rate was increased, as in March 1952”. Failure to follow this plan has cost HM Treasury £11 billion, according to NIESR.
The NEF subscription on the other hand follows Lord Turner’s Suggestion not to pay interest on a large number of commercial bank reserve assets, but to continue to pay interest on the remaining marginal assets. This approach has international precedent: this is how it is in the eurozone and in Japan. NEF estimates that HM Treasury would save £57 billion over the next three years if their plan is implemented.
Free money! Where’s the catch?
Well, the NIESR plan is . † † confusing. The authors admit that its implementation would lead to rising interest rates and 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 dealer calling for live price checks is intervening, this “humble first step” could end. † † bad?
And any plan that forces an unplanned and fundamental reconfiguration of any commercial bank’s balance sheet would raise a variety of financial stability issues. It is probably not difficult to argue that the implementation of the plan has even caused a financial crisis. Still, the plan would have resulted in bank revenues being £11 billion lower and government income £11 billion higher.
For policymakers reading this and thinking “yes, but Eleven BILLION!?” one way to ease that itch could be to lower risk by putting in a £11 billion windfall and perhaps not accidentally triggering a financial crisis .
But like Bill Allen (of the NIESR plan) writes, it could adversely affect the financial system and shift QE from an instrument of monetary policy to an instrument of taxation. In addition, taxation would be continuous and unrestricted, taxing commercial banks more heavily than less regulated financial channels. Increasing inventory QE would raise taxes on commercial banks; abolishing QE would lower taxes on commercial banks. This turns the traditional logic of balance sheet operations (where QE is normally associated with easing) on its head.
Some think we should tax the banks more. Others argue that this would only drive up costs in society, increase the risks of financial instability and hinder growth. If the Chancellor wanted to tax the banks more, why not… er… tax the banks? It is illogical to forever tie this decision to the decision on how to conduct the desired monetary policy stance.
That said, we see a strong case for accelerating the Banks glacial timetable to settle QE, or to auction new sterilization bonds into the system – and return to the reserve averaging system of yore. Coincidentally, these reserves would really require no compensation.