The latest monthly data on the UK’s public finances included the first of many payments from the Treasury to cover losses made by the Bank of England’s Asset Purchase Facility (APF). This may seem like an arcane subject, but the sums are huge and at least partly avoidable, so bear with me.
First, the technical details. This is yet another unwelcome hangover from Quantitative Easing. Under QE, the Bank’s APF bought government bonds, or gilts, by crediting the accounts that commercial banks hold at the central bank, using newly-created money. These accounts, known as central bank reserves, pay interest at the Bank Rate, which is currently 3%.
The APF also receives interest on these gilts from the government, like any other bondholder, in the form of coupon payments. When these payments are higher than the cost of the reserves, the Bank has been making a profit which it has paid back to the Treasury. This is where it gets interesting. Since 2012, the Treasury has received a whopping £120 billion from this source.
Unfortunately, the Bank Rate is now higher than the average interest rate earned on the APF’s gilt holdings. The Bank will also be realising losses on some gilts when they are redeemed or sold back at lower prices than the APF originally paid for them. The Treasury will have to compensate the Bank for these losses.
The Office for Budget Responsibility has estimated that these losses will amount to £133 billion between now and March 2028. The accounting here is complicated, but the basic point is that this is cash that the Treasury has to find from somewhere, presumably by even more borrowing.
This raises a number of questions. For a start, is it right for the Treasury to compensate the Bank for these losses? My answer here is a qualified yes. The Bank is part of the public sector and wholly owned by the government, so the Treasury would be impacted by any profits or losses anyway.
What’s more, the APF was established under Labour in 2009 and has always been indemnified by the Treasury. The timing of payments is now based on a 2012 agreement between the Bank of England and George Osborne. Much as I would love to bash the former Chancellor here, this was a reasonable deal.
Originally it was anticipated that the QE would not last long and any profits or losses would be dealt with when the APF was wound up. But as QE was extended the APF started to make big profits and it made sense to transfer this surplus back to the Treasury.
Nonetheless, this is still an uncomfortable arrangement. It blurs the lines between monetary and fiscal policy. QE was supposed to be about controlling inflation, not making it easier for the government to borrow or to manage its cash flow, or as a way for the Bank of England to make (or lose) money.
This arrangement also flattered the government’s finances when the APF was making a profit. Now the opposite is happening, increasing the amount of gilts that have to be issued to meet the government’s requirements for cash.
It is right as well to ask whether the Bank of England should be paying as much interest on reserves in the first place. The Treasury, and some at the central bank, have resisted calls to make savings here. Officials have argued that this would amount to an additional tax on commercial banks, that it would complicate monetary policy, and even that it could further damage the UK’s credibility in global markets.
The first of these arguments is perhaps the strongest. UK banks already pay higher taxes than most companies, including a surcharge on their profits and a levy on their balance sheets. Any reduction in their interest income would inevitably be passed on to customers, especially if this reduction is large enough to make a meaningful difference to the public finances.
However, the full payment of interest on reserves could also be seen a subsidy to banks, even a ‘windfall’, which is increasingly hard to justify as the massive programme of QE has multiplied the cost. Bank reserves are essentially a form of cash, which does not usually pay any interest.
Officials also have a point in arguing that paying interest on reserves is an important transmission channel for monetary policy. By raising or lowering this rate, the Bank of England can influence the opportunity cost of holding reserves relative to other assets, and influence borrowing costs throughout the economy, in a relatively simple way. But it has other tools that can do this too, including ‘quantitative tightening’, and direct lending or borrowing in the markets.
The weakest argument is surely that reducing the interest rate paid on reserves might harm the UK’s credibility. This option may well be less damaging to the economy than some combination of more borrowing, bigger tax increases, and more cuts in public spending. And monetary economists, both here and abroad, have always been split on whether reserves should be remunerated at all.
It therefore is worth at least exploring a middle ground. A balance could be struck where interest is still paid on central bank reserves, but at a lower rate than the current Bank Rate, or where the full rate is only paid on part of the reserves.
In summary, the Treasury guarantee on the Asset Purchase Facility and the payment of interest on reserves were not a big deal when APF holdings were small and official interest rates were low. However, the changing circumstances now justify a rethink.
This article was first published by the Daily Telegraph on 22nd November 2022