MNI INTERVIEW: BOE Tightening Plan Flawed-NIESR's Mortimer-Lee

The UK faces a difficult monetary tightening path, with the speed at which the Bank of England plans to shrink its balance sheet dictated by the pace at which it originally purchased gilts and the Treasury set to be hit by soaring funding costs as interest rates rise, Paul Mortimer-Lee, National Institute of Economic and Social Research Deputy Director and a former senior BOE economist, told MNI.

"Running off the debt in line with maturities is, I think, a nonsense policy because this says the degree of monetary tightening you deliver depends on the maturity of the debt you happen to hold," Mortimer-Lee said in an interview.

"When you bought this debt you never envisaged that you tightened policy in June 2022, for example. You should make a conscious decision to run the debt off at a rate that you decide is appropriate at the time," he added.

The BOE, which has accumulated GBP875 billion in gilts via quantitative easing, will cease to replace maturing debt once it has raised Bank Rate, currently at 0.1%, to 0.5%, something it looks likely to do by mid-2022 at the latest. Once Bank Rate hits 1.0% it will consider active sales of gilts. (MNI has looked at BOE tightening strategy here: MNI INSIGHT: BOE Clarifies Tightening Strategy, Focus On Rates)

BOE debt sales may prove challenging to the Treasury, whose funding cost on the 40% of outstanding public debt held by the central bank is Bank Rate, paid on the reserves created to buy the bonds.

QE INDEMNITY

"The government has funded itself by overnight deposits and that is a bit scary. When you have a very short debt maturity overall then your debt dynamics can become quite adverse when interest rates go up," Mortimer-Lee said.

The Treasury is also liable to pay an indemnity to the BOE for any losses it incurs in the sale of gilts, potentially delivering a double-whammy to the public purse.

"Does the Treasury really want to pay huge chunks over to the Bank of England? Where does it get the money from if the Bank suffers huge losses on its gilt portfolio? It has to issue in the market, and so there is a potential funding problem with having so much debt at floating rates," Mortimer-Lee said.

One proposal from NIESR has been to compel banks to switch their central bank reserves into government debt, but Mortimer-Lee points out that this would be equivalent to a heavy tax on banks. BOE Governor Andrew Bailey has also opposed restricting remuneration of central bank reserves on the grounds it too would act like a tax on banks.

The prospect of such complex debt dynamics is also making life difficult for the UK Office For National Statistics, which has to separate out Treasury and Bank of England liabilities in measures of public borrowing. The problem has only been made more acute by the decision by Chancellor Rishi Sunak to adopt a fiscal target for a falling ratio of debt-to-GDP excluding the BOE.

Mortimer-Lee was critical of the new fiscal rule, noting that gilts held by the BOE affected market rates for bonds and therefore public financing costs.

"The refunding need is the same if the Bank holds this stuff or the other people hold this stuff," Mortimer-Lee said.