There’s always more that can — and should — be said about quantitative tightening.
Toby’s been all over the topic lately, as it moved from obscure fixation of monpol saddos to mainstream policy discussion.
We’re going to assume you’re au fait with the basics of the debate (joyous to write that this is finally actually a debate), but here’s a quick rundown:
— The Bank of England bought loads of gilts via the Asset Purchase Facility to provide stability and keep prices low during some recent crises that you may have noticed.
— Reducing the accumulated gilt pile is producing hefty losses for the Treasury, which indemnifies the BoE against losses.
— The UK is paying banks large dollops of interest simply for holding reserves.
— Questions like “should we have an indemnity” and “should we be giving banks large dollops of interest” (which are highly connected but not exactly the same question) have become somewhat prominent during this otherwise econ-turgid General Election campaign.
From this, roughly three solutions, primarily focused on the interest of reserves issue, have emerged:
1) Don’t change anything (currently the Bank of England’s stance).
2) Halt all QT, stop paying interest on reserves, convert all APF holdings to 75-year gilts, lawyer up, delete Facebook, hit the gym (some of which are the Reform Party’s stance).
3) Anything between options 1 and 2 (the New Economics Foundation, Chris Giles, Gordon Brown, Lord Adair Turner, Sir Paul Tucker and Sir Charlie Bean options all land in this category).
Thus far, presumed Chancellor-to-be Rachel Reeves has ruled out a change, but Reeves is a politician so we don’t consider that to mark an end to the issue.
What if there were a fourth way? Excitingly, Barclays reckons there is.
Analysts Jack Meaning, Abbas Khan and Moyeen Islam write in a note today:
A combination of transferring gilts from the APF onto the BOE’s balance sheet, granting the BOE the right to retain seigniorage and implementing a deferred asset accounting convention, could provide significant fiscal savings and greater clarity over the BOE’s balance sheet without the costs of other policies suggested.
They lay out a “3-step” policy “that would work”:
Given the weaknesses of the policies above, is there a route that would allow a reduction/elimination of the fiscal burden from both interest losses and valuation losses without having a negative impact on the macroeconomy or the implementation or independence of monetary policy? We suggest there is. It would require three innovations, each of which individually have precedent in other contexts:
1) A transfer of the assets held on the APF to the Bank of England’s own balance sheet. By September 2025, the APF is likely to hold around £465bn of gilts based on their par value, and have a loan outstanding to the BOE of £600bn (Figure 2). If these assets transferred to the BOE’s balance sheet at par, this would imply a loss of £135bn which, on current arrangements, would need to be made good by HMT. However, the second two pillars of our proposal would mitigate this fiscal cost. Although on a smaller scale, there is a precedent for the BOE bringing items from the APF onto its own balance sheet: in 2018 the TFS’s £127bn balance was transferred alongside new financial arrangements that allowed the BOE to take more risk on its balance sheet.
2) A legislative change to allow the BOE to retain seigniorage income. Historically the BOE has not been able to retain seigniorage income.4 This is unlike other central banks and has been cited by Governor Bailey as a reason for why the BOE could not use the same methods as the Federal Reserve, for instance, to manage losses without calling on the fiscal authority. However, it would be a relatively simple piece of legislative change (to the Bank Charter Act 1844) to enable the BOE to retain this income.
3) A decision to frame losses from the gilt portfolio as a deferred asset, as per the Fed. The final piece of the puzzle would be for the BOE to register the c.£135bn of losses from the APF shift as a deferred asset. This would mean that BOE could continue to operate without the need for an immediate capital injection from HMT as it could earmark future seigniorage income to cover the losses, spreading them over a much longer period than just the moment in which they are realised. There is strong international precedent for such an arrangement, with the Federal Reserve being the most obvious example.
They estimate such a policy could save the Treasury £20bn a year, which “could more than cover the real-terms cuts to unprotected government budgets implied by current spending plans across both the Conservatives and Labour, as flagged by the IFS”.
Here’s their simplified diagram of how such a policy would work — putting the APF into standby mode:
This change in approach, they reckon, would have the added benefit of simplifying the relationship between the objectives of the Monetary Policy Committee (on whose behalf deputy governor Sir Dave Ramsden has floated the possibility of running the APF down to zero) and the elevated levels of reserves than lenders are now longing for.
At present, the situation creates a potential conflict, as the BoE’s markets directorate — which runs the APF — could be put into a situation where it is required to move in two opposite directions simultaneously: winding down the APF to build dry powder for future easing at the MPC’s behest, while also facing a financial stability onus to maintain reserves.
Barclays writes of its proposal:
It would allow for clarity between gilts held to meet the structural demand for reserves and those held more directly in pursuit of the monetary policy objective. The former would be those gilts held, largely to maturity, on the BOE’s own balance sheet without government indemnity and with oversight from the BOE’s executive, rather than the MPC. The latter, perhaps characterised more formally as increases in the supply of reserves independent of shifts in demand designed to ease or tighten monetary conditions, or QE/QT, could still be owned and determined by the MPC with arrangements on the precise vehicle and associated indemnity determined when the need arose. [ . . . ]
Of course, no policy is a silver bullet, although in this case we think the difficulties are far outweighed by the benefits.
The note flags three potential issues. The first is the potential implications of shifting this deferred asset onto the BoE’s balance sheet, which the authors see as non-problematic:
With the weighted average coupon rate of the remaining APF holdings around 2.75% and the cost of supplying reserves currently Bank Rate, it is likely that the deferred asset would be in place for a significant period of time and may even increase at first while Bank Rate was higher than the return on the portfolio. However, this would not create a fiscal burden and there is no reason to think that a central bank could not run with a deferred asset effectively indefinitely.
On the second — where they go full circle and quote Toby’s recent piece on the topic for mainFT — they note the vibes might be bad:
The second potential downside is the perception of looking like the rules have been changed halfway through the game. The Treasury has benefited from the positive flows from QE for over a decade and now QT brings costs they don’t want to meet them. Toby Nangle recently described the UK adopting the US-style accounting practices – one of the pillars of this proposal – as having “an aura of perfidiousness”, but went on to say it could be “the lesser of two evils”. We tend to agree and think that ultimately, this could lead to a perception of less political interference in the QE/QT process.
Finally, there’s the rate risk:
Third, it could be argued that this is the BOE taking on more risk directly onto its balance sheet, making it susceptible to changes in credit or interest rate risk. However, given the BOE is likely to hold these gilts to maturity to back structural reserve holdings (see below) and that gilts are probably the most secure form of long-term asset to back sterling reserves, we think this risk is limited.
Clearly, there’s an element of kicking the can here, and we can’t finish this post without acknowledging the perennial point that all of this discussion is partially a product of the UK’s absurd fiscal framework.
How things settle on the shifting goalposts point feels like a somewhat open question at the moment. Assuming the indemnity set-up remains unchanged, it can benefit the governments by providing a fiscal tailwind. It can also — as we’ve quickly seen post-Covid — not do that, and we find it hard to believe any politician would want to repeat the events of recent years. But then again, strange and inexplicable things happen all the time.
Still — there seems to be a lot to admire in this proposal. So perhaps the biggest question is this: will Reeves be willing to grasp the nettle?
Further reading
— What to say when you’re asked your view on Bank of England reserve tiering
— Getting into the weeds of active QT and UK fiscal rules
