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With six short words, Rachel Reeves has a golden opportunity to make her mark as chancellor if Labour wins on July 4. She would be able to save billions of pounds, enhance the independence of UK monetary policy and fund an immediate boost for public services. The words would augment the Bank of England’s monetary policy remit, requiring the central bank to “have regard for the public finances” so long as it can effectively implement monetary policy.
It can. At present the BoE pays 5.25 per cent interest overnight on the money it created to buy government bonds under multiple waves of quantitative easing since 2009. It still holds roughly £700bn of bonds that were purchased and they earn a return of about 2 per cent. Netted off, the annual interest rate loss is around £23bn a year, a little shy of 1 per cent of GDP.
The central bank pays 5.25 per cent on reserves so that it can set the short-term policy interest rate at that level. It is effective, but not the only way to control short-term rates.
Instead, it could require banks to hold a fixed amount of money without interest, paying 5.25 per cent only on a small part of the reserves. Such tiering is used in a modest form by the European Central Bank, in a more substantial form in many emerging economies and was admitted to the BoE’s toolkit when it was thinking about setting a negative interest rate earlier this decade. It carries no threat to independent monetary policy and would limit the fiscal consequences of monetary policy decisions, arguably enhancing independence.
The beneficial politics of such a move are obvious. If the BoE tiered reserves, saving some of the £23bn annual cost, it would lower measured public spending (net interest payments), allowing a new government to increase spending in other areas without raising measured taxes or borrowing. The opacity of the mechanism might be bad economics but it would help the politics: it is better to lack transparency in government than to underfund public services.
Unlike some proposals to change accounting rules or cash flows between parts of the public sector, tiering reserves represents a genuine saving and does not merely flatter the public accounts by creating a hidden liability stored up for future generations.
Of course, with savings come losers. Initially this would be commercial banks, which have enjoyed significantly higher profits since the pandemic. That will hurt bank shareholders and senior executives, but competition should ensure that much of the ultimate impact will fall on customers, raising interest rates and lowering deposit rates. The BoE would then want to reconsider the interest rates it sets to keep on track to meet its inflation target.
One difficulty is that Andrew Bailey, BoE governor, still needs to be persuaded. In 2021 he said the policy would be a tax on banking. The truth is that it would lower public spending.
This year he rejected the idea again, when it was proposed by former deputy governor Sir Charlie Bean, saying, “I do not think that the Bank of England can decide to do something like that on its own.” Sir Paul Tucker, another former deputy governor, has also supported the idea, but Bailey is steadfast. Last month he said the BoE could not do it because “as a matter of history, we do not have such minimum reserve requirements [for commercial banks]”.
This is where the six words matter. Added to the remit, they would prompt more imagination in Threadneedle Street. In truth, they should not be needed because the BoE already has a duty to support the government’s economic policy objectives, including “responsible fiscal policy”. A wise central bank would recognise the scope to do things differently and come forward with suggestions.
The BoE has not demonstrated wisdom. It needs a nudge.
