Quid Pro Quo of quantitative easing at the BoE, a politically toxic time bomb

“This probably means that the taxpayer is responsible – big time”, – Rabobank.

© Bank of England

The unwinding of the Bank of England’s (BoE) quantitative easing (QE) programs begins in earnest in November and could have politically toxic implications for public finances which have so far largely slipped under the radar, with the risk being that this drains tens of billions from the budget every year.

UK government finance and fiscal policy has risen to dominate the political conversation in recent weeks, so the costly quid pro quo of the UK Treasury’s arrangement with the Bank of England could attract more attention. Watch out as the quantitative tightening (QT) process gathers pace next month .

This will see the BoE start actively selling government bonds from a portfolio that had reached £875bn before the start of the quantitative tightening process in February with a decision not to reinvest £27.9bn. sterling of proceeds received as bonds held on its balance sheet matured in March.

“The cost of QT [quantitative tightening] is likely to be large. The blow to public finances is twofold. On the one hand, QT loses money because the Treasury takes the losses from the BoE when gilts are sold for less than paid,” says Imogen Bachra, head of UK rates strategy at Natwest Markets.

“On the other hand, although the QE gilts are not being sold, the BoE is paying the discount rate on the reserves of around £900bn it has created to buy them. Plus the rate of discount increases, the more expensive those interest charges become,” Bachra and his colleagues said in a research briefing in early October.


Source: Natwest Markets. Click on the image for a closer inspection.


The BoE is aiming to reduce its balance sheet by around £80bn over the coming year, but this process will most likely see it sell bonds in a market where prices are lower than those paid during its various periods of quantitative easing.

This means that the BoE will have no choice but to book losses as a result of its accelerated quantitative tightening program and the catch for the UK Treasury is that the taxpayer will be responsible.

The UK Treasury bill for the currently planned sales is estimated at just over £11bn, or just over 0.5% of GDP, but that’s not the only way quantitative tightening will weigh on public finances in the years to come.

“While the actual cost will depend on the realized path of the discount rate, it likely means the taxpayer is on the hook – high time,” writes Stefan Koopman, senior macro strategist at Rabobank, in a research briefing the week. last.

“Even without the negative ‘stock’ effects of actively selling gilts at values ​​well below the purchase price, the negative ‘flow’ effect would be, roughly, an additional £20 billion a year at over the next two years,” he added. .


Source: Rabobank. Click on the image for a closer inspection.


The problem for HM Treasury is that as the BoE discount rate rises above its end-October level of 2.25%, the bank will have to pay the difference between that rising interest rate and the bond yield. of British state that it holds. its balance sheet.

This is likely to add to the book losses booked by the BoE and, as the bank is indemnified by the UK Treasury, against any losses arising from its quantitative easing activities, these additional losses will also have to be reimbursed from the Chancellor’s budget.

The exact cost of this is difficult for economists and analysts to estimate, as it will depend heavily on the increase in the Bank Rate and how the UK government bond market reacts to any further increases, although many consider the cost could exceed £20 billion. per year.

These costs are the quid pro quo for an arrangement that has benefited HM Treasury to the tune of £120 billion over the past decade when interest rates have remained low because the BoE has repaid the Exchequer all interest payments made in relation to debts held on the bank’s balance sheet.

“The rapid rise in the Bank Rate means that these payments to the Treasury are about to reverse. Interest paid on reserves will now exceed coupon interest income earned. It is uncertain to what extent – it depends both on how big and how fast the discount rate goes up, but also how fast the BoE reduces its holdings of gilts,” Natwest’s Bachra said recently.


Source: Natwest Markets. Click on the image for a closer inspection.


“The heatmap shows the cumulative net interest expense by the end of 2026 (in billions of pounds sterling) under different scenarios of discount rates and active sales,” she added in reference to the graph below. above.

The bill for more than a decade of QE is set to arrive at Her Majesty’s Treasury door just as the government seeks tens of billions in budget savings to put national finances on a more sustainable path .

This will in all likelihood require wider and deeper cuts in public spending, which could be politically toxic for an already struggling government.

Quantitative easing has been used repeatedly by the BoE over a period of more than a decade when its main monetary policy tool, the discount rate, was already at record highs and near lows. from zero and as part of an effort to ensure the economy delivers on the medium-term 2% inflation target.

It was a period in which inflation spent much of its time below the 2% target and involved purchases of what were mainly government bonds, although since then rising inflation rates forced the BoE and other central banks to reverse course and start tightening monetary policy.

So far, this has involved raising the Bank Rate from 0.1% to 2.25% and allowing the QE-induced expansion of its balance sheet to partially reverse by no longer reinvesting the money received from maturing bonds he holds.

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