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Any attempt to limit the impact of rising interest rates on the government's debt servicing costs by restricting remuneration on banks' reserves at the Bank of England, would risk backfiring, former BOE Deputy Governor Charles Bean told MNI.
With the BOE currently working on its review of tightening strategy, prominent external economists have suggested the government could try to keep a lid on its debt servicing costs via such steps as tiering or even ending central bank reserve remuneration. As a result of BOE bond purchases, which are paid for by bank reserves, the effective cost to the state of a large portion of government debt is now Bank Rate, currently at 0.1 %. But this is likely to rise, and introducing a tiered system with interest only paid on reserves in excess of a minimum requirement or even axing remuneration altogether could, on paper, save substantial costs.
Bean, however, now a senior figure at official fiscal forecaster the Office for Budget Responsibility, said there will be "no free lunch" for the public finances when it comes to tightening and that any such step would come at a price.
Paying differentiated amounts on Bank Rate, currently defined as the rate paid on reserves and referenced in many private contracts, would disadvantage banks, risking fuelling shadow banking, as well as leave the door open to legal challenges, Bean said.
"If you introduced tiering … where you pay different rates on different tranches of the reserves then there is a question about what is Bank Rate? Is it the average rate? Is it the marginal rate? Stuff like that. You could see some litigation taking place as a result of changes in the structure," Bean said.
There is no easy way to avoid the hit to the public finances from rising interest rates, he said.
"Anything that anybody has suggested … all end up having some real consequences. Which is not to say that you can't do them, but you shouldn't go into this thinking 'ah, there is a costless way out of this.'"
The BOE's internal review is reassessing its current pre-declared strategy of only starting asset sales once Bank Rate has risen to around 1.5%. Increasing Bank Rate, as a more potent and precise instrument than quantitative tightening, would have obvious attractions if inflation proves to be persistently high, Bean said.
"I would be very surprised if they chose to do it purely through QT if inflation has hit 5%. The only circumstances in which they might is if they were still taking the view that this is a temporary blip," Bean said.
"I have always taken the view that because you do have more idea about the impact of changes in Bank Rate than you do about asset purchases or sales that, ideally, you want to have the short rate as your monetary policy instrument."
One approach, cited by BOE Governor Andrew Bailey, would be to run down the Bank's vast GBP875 billion gilt stock on auto pilot, setting a steady, and relatively gentle, pace of sales by 'natural run-off', allowing gilts to mature without replacement.
"I could see a world where the Bank decides just to shrink the balance sheet relatively slowly," Bean said adding that in his time when the possible pace of gilt sales was discussed "you were talking about something of the order of maybe GBP50 billion a year. Maybe you could go to GBP50 billion in six months if you really push it."
Active gilt sales would expose the Bank's Asset Purchase Facility to the risk of heavy trading losses -- as much as GBP114 billion if all the BOE's current gilt holdings were sold at par, according to OBR figures. Thesewould have to be indemnified by the government. Natural run-off, however, would also come at a cost, as it too would tend to push longer rates higher.
Market participants have been expecting gilts to be rolled over when they mature, Bean noted.
"So deciding not to do that and just not replacing them when they mature, which then means that the government has to sell more new gilts into the market, would equally put upward pressure on long term rates," he said.