MNI INSIGHT: BOE Unmoved As Debt Puts Focus On Reserve Tiering

The Bank of England has no intention of heeding calls to stop paying interest on the reserves it has created to buy government bonds, despite growing concern that tightening monetary conditions might cause an expensive spike in U.K. borrowing costs.

Pandemic quantitative easing is set to push the BOE's gilt holdings to 875 billion by the end of the year, a third of the UK's gross public debt. As the Bank returns interest it earns on the bonds to the Treasury, the effective cost of the debt to the public sector becomes Bank Rate, currently at 0.1%, which is paid on the reserves used to buy the gilts from pension funds and other institutions. This compares to the average 2.1% on gilts acquired under quantitative easing.

This makes for very cheap public funding. But if the economy recovers and Bank Rate is increased, the UK's debt servicing costs could rise dramatically. Former Monetary Policy Committee member Charles Goodhart and former Financial Services Authority chief Adair Turner told a parliamentary enquiry last month that it was inevitable that the portion of reserves used to buy gilts would be made interest-free, with other reserves still remunerated in a tiered system.

STEALTH TAX ON BANKS

The Bank though would push back hard against changes to reserves remuneration, which would upend the mechanism designed to keep short-term market rates in line with the policy rate in place since the global financial crisis. It would also violate the prohibition on monetary financing under the Maastricht Treaty.

BOE Governor Andrew Bailey made clear his opposition at a Resolution Foundation event, saying tiered remuneration would be a tax on banks as well as disrupting the UK's monetary policy framework.

A more realistic way of easing the debt burden would be a relatively rapid unwind of the Bank's bond holdings, with the central bank currently reviewing its strategy for an eventual monetary tightening. One way of facilitating this would be to lower the 1.5% Bank Rate threshold before gilts can be sold or allowed to mature without replacement.

Bailey is on record as being in favour of running down the size of the Bank's balance sheet to create policy space to deal with any future shocks. A swollen balance sheet has been identified by some commentators as a threat to central bank independence, as governments could apply pressure for policy rates to be held at unsuitably low levels.

Charles Bean, former BOE deputy governor and now at the Office for Budget Responsibility, made the case for the natural run-off of gilts in an MNI interview last month. This would break with the current approach of replacing expiring bonds.

A QE unwind could even start before any Bank Rate hike or after only modest increases, with MPC member Michael Saunders saying in a question-and-answer session at the end of March that there was "an argument to set a slightly lower threshold" than the current 1.5% and that a decision or on sales or run-off would be taken 'at the time'.