Reuters. On October 22, 2021, people walk past the Bank of England in London, Britain. REUTERS / Tom Nicholson
By Mike Dalan
LONDON (Reuters) – Markets dominated by Bank of England interest rate hikes over the next week, with UK policymakers now beginning to unravel an uncomfortable tangle of monetary and fiscal policy provided by central bank bond purchases, or ‘quantitative easing’.
On Wednesday, the UK’s finance minister, Rishi Sunak, presented his latest government budget, perhaps relieved by the prospect of borrowing less than initially predicted after the epidemic hit, but also under pressure to outline a framework for stabilizing public finance in the medium term.
However, the BoE’s rhetorical twist in the last month has led currency markets to expect its historically low 0.1% growth at the end of the year, creating inflationary expectations. And it underscores the long-running debate over how risky UK government debt is now for high rates.
The Office for Budget Responsibility – the British government’s own budget watchdog – has flagged the issue throughout the year and emphasized the pressure of higher interest rates on the government’s huge debt pile – which is 100% of national production 20 years ago.
And the financial exposure of the Treasury to high short-term interest rates raises concerns for many observers about the central bank’s autonomy and willingness to tackle inflation if it becomes a problem. The BoE only gained operational independence from the government in 1997 but still reports to the Treasury, which sets its inflation target.
In essence, the problem involves a maturity discrepancy due to on-off QE programs that have lifted the BoE’s balance sheet since the 2008 banking crash and again after the epidemic – mainly to keep a lid on the cost of long-term debt.
QE involves buying most of the gilt from commercial banks in exchange for interest-bearing reserves at the central bank instead of cash. And the floating interest rate on that bank reserve is the ‘bank rate’ that the BoE uses to adjust its overall monetary policy.
Raising short-term interest rates, including a trillion-dollar balance sheet, has similar problems for the central bank and the government.
With interest rates falling, it was a win-win. Not only is the cost of lending services limited, there is a big disadvantage for the central bank as it offers lower interest rates than long-term loans on its balance sheet on the bank reserves. And it sends those profits back to the treasury.
Earlier this year, the OBR estimated that the total positive cash flow from the Bank of England’s so-called asset purchase facility to the Treasury alone totaled 3 113 billion ($ 156 billion).
But everything comes to mind when bank rates start to rise – probably faster than long-term rates – and especially if the yield curve is reversed. The Treasury compensates all BoE losses.
The OBR estimates that about one-third of total government debt – or 75 875 billion ($ 1.2 trillion) – will be kept in bank reserves by the end of next year. The bank rate of market value is already nine times higher than today – an increase of about 90 basis points from 0.1%.
The cost of a one-point point increase in interest rates across the spectrum on integrated public sector liability will be about half a percent of GDP in 12 months.
Another implication is that the average maturity of a combined public debt is only 2 years – dangerous for any period of interest rate hike, rather than the outstanding gilt of having the longest medium maturity of the G7 in more than 14 years.
According to the OBR, this new scenario – about a quarter of UK government debt is now secured by inflation – means that an explosion in inflation does not have the positive effect on the debt ratio that it had decades ago.
In an article published by VoxEU this week, economists Charles Goodhart and Manoj Pradhan – authors of a 2020 book that is undergoing a structural revival of global inflation – think that central banks need to be wary of sudden and volatile policy changes to restore credibility despite inflation. Continues
But they warn that the persistence of large central bank balance sheets in the face of rising interest rates raises all sorts of political questions about how commercial banks can give larger and larger returns on reserves and how much bank policy spends directly on the treasury.
“At a time when the debt-service ratio is deteriorating, the need for increased taxes and the transfer of large sums of money from public purses to commercial banks to keep reserves at the central bank will become politically unpopular,” they wrote. “You don’t have to be a popular politician to see how this combination can turn out … it’s hard to defend.”
Goodhart and the chief added, “Central banks will have to bear the capital loss on their holdings and may need recapitalization from the government.” “That process needs to be structured in such a way that the independence of the central bank is not questioned.”
There are some suggested solutions. In July, economists at the Independent Institute of Economic and Social Research, an independent UK think tank, said that the maturity disparity should be reduced by switching to long-term gilt in the Treasury to reduce the duration of the Treasury and the central bank portfolio.
“The goal of our proposal is to limit the presence of conflict between the Treasury and the central bank when macroeconomic policies need to be tightened,” they wrote.
(Mike Dullan, via Twitter (NYSE :): @reutersMikeD)