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MNI INTERVIEW2: UK Treasury Should Clarify QE Deal With BOE

The UK Treasury should explain how it would meet a promise to cover any potential BOE losses on QE, NIESR chief Jagjit Chadha tells MNI.

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The UK Treasury should clarify how it would meet the terms of its indemnity agreement with the Bank of England under which it promises to make good any losses on bond purchases under its quantitative easing programme should rates rise, National Institute of Economic and Social Research head Jagjit Chadha told MNI.

While so far the BOE's Asset Purchase Facility has been highly profitable, with the profits handed over to the Treasury, it is uncertain how the government would honour the indemnity agreement backing QE, Chadha said in a joint interview with NIESR Visitor Philip Turner.

"Exactly how would it be enacted? Before the losses? Would the Bank have to ask for it after the losses? I think there needs to be much more clarity as to how that option would be exercised were that option to come into play," Chadha said. "You can't have a situation where the Bank potentially looks bankrupt and then has to go cap in hand to the Treasury at, say, around election time. That would not be a great situation to find ourselves in."

RESERVE REMUNERATION

The indemnity agreement is only one facet of the increasingly salient question of the relations between the BOE's swollen balance sheet and government finances. While quantitative easing effectively reduces public borrowing costs to Bank Rate, because gilts purchased by the BOE are paid for with interest-bearing reserves while coupon payments are refunded to the Treasury, some economists, including former MPC member Charles Goodhart, have suggested that the government could push for an end to reserve remuneration once rates begin to rise.

Such a move could prompt banks to reduce their reserve holdings, potentially reducing monetary policy's control over short-term rates and inflation, according to Chadha, who said the Bank might be well advised to reduce its asset holdings.

"Some QE looks a very optimal strategy. But at some point it is such a large player in the bond market it changes the very structure of the market. There may be more of a prima facie case for reducing the quantum of QE and draining some reserves even before we start to raise interest rates," he said.

Turner, a former senior manager at the Bank for International Settlements, said the Bank could potentially suspend remuneration on just a portion of its reserves, with another possibility being to swap reserves for short-term paper to smooth interest rate exposure.

So far, the BOE has purchased around 40% of the UK's debt stock through QE. Some GBP110 billion in profits from the gap between gilt rates, which average some 2.1% on the debt stock, and Bank Rate, currently at just 0.1%, have been returned to the Treasury.

CROWDING OUT THREAT TO GILT DEMAND

Growing global demand for safe assets over the past two decades has also favoured the UK public purse, despite surging government borrowing during the pandemic, Turner said, adding that the vast U.S. fiscal stimulus could soon crowd out this trend, by driving up debt costs across the world.

Emerging markets generally do not produce safe assets, even as their citizens require more of them as their economies expand. This has substantially increased the limits on UK government borrowing, with demand for sterling bonds increasing by an amount roughly equivalent to national GDP since the turn of the millennium while gilts held steady at just under 6% of international debt portfolios, he said.

This friendly environment may be about to turn more difficult.

"This zero nominal rate may go, particularly if the United States …. starts a big investment programme on top of more conventional fiscal expansion and drives up the world's long-term

interest rates," Turner said, "The opportunity countries have had up to now may be about to disappear."