A cheap monetary policy? reserve judgment
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 interest rate hike has come under increasing scrutiny in recent weeks. The BOE’s balance sheet has ballooned to almost £900bn after waves of quantitative easing. And while there are fiscal dividends attached to effectively shortening the rate structure – around £123bn at the end of April – there could be fiscal costs as rates rise. So what to do?
First, a brief recap of the mechanics.
Almost 15 years later, there is still no agreement on how QE should work as a policy, but operationally it is simple. The BOE bought about £875 billion worth of interest-bearing gilts as well as some corporate bonds. He paid for those gilts with new central bank reserves. Thus, the assets of the Bank’s balance sheet have swelled (the gilts!) as have the liabilities (the reserves!).
Prior to QE, the BOE set overnight interest rates by adjusting the amount of (unremunerated) 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 discount rate.
QE meant that large quantities of reserves were created, so the fine adjustment of reserve quantities to the target price could no longer work. The Bank had lost its ability to set a floor on rates and recognized: a) that financial institutions would face problems of such magnitude that negative rates could be restrictive rather than stimulative; and b) there could be unforeseeable negative consequences of delving 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 to the Bank receiving coupons on the gilts it had purchased and paying interest on the reserves. The positive carry was, and continues to be, huge:
But now, with rising interest rates, the interest costs attached to the liabilities of the QE book (interest on reserves) threaten to outpace the income on the active side of the QE book (the gilts).
Will this lead to the bankruptcy of the BOE? Absolutely not! Leaving aside the fact that it is difficult for a central bank – which can literally think up as much new money as it wants – to exhaust its own claims, the Bank took care, at the start of QE, to s to ensure that the entire program was indemnified by Her Majesty’s Treasury. In return, the Treasury received all this huge positive report.
But as far as depicted, it seems the taxpayers are responsible for the P&L of one of the biggest long-running trades in history. At a time when yields are rising. And net cash flow becomes negative once the discount rate moves north of 2%.
Two UK think tanks, the National Institute for Economic and Social Research and the New Economics Foundation, have released plans to keep this positive carry.
The NIESR plan draws on the ideas of Bill Allen, a former BoE division chief for market operations and economic historian who wrote the definitive British monetary history of the 1950s. Britain had a debt to GDP ratio of 175%, and by 1959 it had fallen to 112% despite modest growth and low inflation. How? Allen argues that outright financial repression – the direct control of banks and credit by monetary authorities – was the answer, and that the lessons of November 1951 can be borrowed to financially repress banks today.
Specifically, the NIESR argued last summer that banks should be mandatorily allocated newly created two-year government securities to commercial banks at off-market prices in exchange for their reserves “as a way to drain assets.” liquids from the banking system and isolate the public”. finances to some extent of the costs incurred when short-term interest rates were raised, as they were in March 1952″. Failure to comply with this plan has, according to the NIESR, cost Her Majesty’s Treasury £11billion.
The NEF scheme, on the other hand, follows Lord Turner’s suggestion to pay no interest on a large block of commercial bank reserve balances, but to continue to pay interest on the remaining marginal balances. This approach has an international precedent: this is how things are done in the euro zone and in Japan. NEF estimates that HM Treasury would save £57billion over the next three years if its plan is adopted.
Free money! Where is the trap ?
Well, the NIESR plan is . . . embarrassing. The authors concede that implementing it would cause yields to soar 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 trader calling for live price checks constitutes intervention, this “small first step” could come to an end. . . wrong?
And any scheme that forces an unplanned and fundamental reconfiguration of every commercial bank’s balance sheet would raise a variety of financial stability questions. It is probably no exaggeration to say that the implementation of the plan may even have triggered a financial crisis. Yet the plan would have led to bank revenues being £11bn lower and government revenues £11bn higher.
For any policy makers reading that “yeah, but ELEVEN BILLION!?” thought, a less risky way of eliminating that itch might be to introduce a one-off £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 practices that other major central banks have implemented (albeit only during periods of negative interest rates).
But as Bill Allen (of the NIESR plan) writes, this could have adverse consequences for the financial system and would shift QE from a monetary policy instrument to a taxation instrument. Moreover, taxation would be continuous and scalable, with commercial banks being taxed more heavily than less regulated financial channels. Increasing QE stock would push taxes on commercial banks higher; the end of QE would reduce taxes on commercial banks. This upsets the traditional logic of balance sheet operations (where QE is more normally associated with easing).
Some argue that we should tax the banks more. Others argue that it would only push costs into society, increase the risks of financial instability and hamper growth. If the Chancellor wanted to tax the banks more, why not… uh… tax the banks? It is illogical to forever tie this decision to the decision on how the desired monetary policy stance should be implemented.
That said, we see a powerful argument for accelerating the Bank’s chilling timetable for unwinding QE, or for auctioning new sterilization bonds into the system – and returning to the reserve averaging system of yesteryear. Coincidentally, these reservations would actually require no compensation.