The Bank of England and interest on its reserves enters the election debate

We find ourselves in Bank of England week so let me just cover that off by saying that the General Election will mean no change in policy. The one thing we might get is a clearer guide as to future moves. However interest-rates have come on the agenda via a suggestion from the Reform Party in the UK which has rather lit the blue touch paper on a wider debate and had people looking at an area that is usually in the shadows..

Bank of England Must Stop Paying Interest to
Commercial Banks on QE Reserves
This approach would save around £35 billion per
year and has been endorsed by senior figures at the
Financial Times, New Economics Foundation, and
IFS, as well as two former Deputy Governors of the
Bank of England.

We should not reject the idea because it has the backing of senior figures at the Financial Times and former Deputy Governors of the Bank of England! Even a blind squirrel occasionally finds a nut. But to properly understand the state of play we need to look back in time via the question asked by David Byrne of Talking Heads.

And you may ask yourself, “Well, how did I get here?”

That word temporary

Our journey starts pretty near to the start of my time here and in particular I am referring to the Bank of England’s first QE bond buying wave which had several tranches but totaled £375 billion. The first warning of the issue above was that around £260 billion was deposited back with it by the commercial banks. That actually raised issues about what QE achieved? But these were rejected as after all these central bankers were extremely clever and this was presented as being only a temporary situation. You may note that if this was the Hitch Hikers Guide to the Galaxy it would be pointing out how much better life would be if no-one in authority was allowed to use that word (temporary).

There was another swerve in this and it is something that in my opinion fooled all those frightfully clever central bankers. Back then we had a Bank Rate of 0.5% which again was supposed to be temporary until we had another frightfully clever Bank of England Governor Mark Carney who after promising to raise Bank Rate later cut it. The point was that we had a sustained period of interest-rates where the yields on the bonds bought were much higher than Bank Rate. These frightfully clever people are financial geniuses! To put it into numbers UK Bank Rate did later get raised but only to 0.75% and then of course was cut to 0.1%. Whereas the bonds were yielding more than 2% so there was a gain which totaled around £124 billion.

Regular readers will recall I kept pointing out that there was an enormous risk here but all the establishment could  see was the words of Stevie V.

Money talks, mm-hmm, money talks
Dirty cash, I want you, dirty cash, I need you, oh
Money talks, money talks
Dirty cash, I want you, dirty cash, I need you, oh

The issue was that they had a VARIABLE rate liability but a FIXED rate asset. To them it did not matter because they locked themselves in an illusion.. In these times they set levels of Bank Rate of 0.5% and 1% as numbers at which they would act on the amount of QE bonds held. But because there was never any sustained rise in Bank Rate it did not appear to matter.

I did warn back in September 2013 that it would be best to start what is now called QT via letting bonds mature and not buying new ones. But the frightfully clever Governor Carney instead bought even more post Brexit. Again he was exchanging present gains for future liabilities. He would have been very popular in government circles as he handed over the cash and of course no-one responsible for the liabilities in that period is anywhere to be found as both Governor Carney and Chancellor Osborne have moved on.

The next step in the saga was the cut in Bank Rate to 0.1% and the Bank of England charging into the UK bond markets as described by the Kaiser Chiefs.

Knock me down I’ll get right back up again
Come back stronger than a powered-up Pacman

This matters because these frightfully clever people were essentially issuing loans in the range 0.5% to 1% for these vast purchases. On the other side of the coin they were borrowing at 0.1%. Again financial geniuses until one points out that they were lending at a fixed rate and borrowing at a variable one. But that did not matter as these same people were issuing Forward Guidance that interest-rates would be low for ages and ages.

Temporary and Transitory

The next part of this story was the rise in inflation which torpedoed the cosy Forward Guidance consensus that interest-rates would be lower for longer. Remember that phrase? They are hoping you wont. The most explicit version of this was when the Governor of the Reserve Bank of Australia issued a public apology for misleading mortgage holders. The irony was that the central bankers had taken on a variable interest-rate risk themselves and on an even grander scale.

It is my opinion that the situation here was a factor in central bankers being late to raise interest-rates. The human response to change starts with denial and they clung to the hope that inflation would fade of its own accord like a drowning man clings to a branch in the water. So one feature of the cost of living crisis was the central bankers indulging in what a polite person would call wishful thinking. The reality is that they failed on both fronts as we have now experienced the cost of living crisis and have their QE liabilities to deal with as well.

Along the way the Bank of England has sold quite a few UK bonds at the bottom. Anybody with any sense knows that buying at the top and selling at the bottom is none too bright. But they are not paying…..

But the fundamental point is that whilst all these frightfully clever people were busy at the Bank of England we saw the commercial banks mostly giving them the money back. So their balance sheet had the liability in the Reform statement. A little care is needed with this as it looks like a subsidy to banks and we are in The Precious! The Precious! territory. Do I think when the numbers were relatively small that the Bank of England was happy funds were flowing to the banks? Yes. After all it has spent this period trying to boost net mortgage lending. Did it think we would end up like this? No. Although that is a failing in itself as after all interest-rates are their job.

Comment

It may seem seductive to say stop it now but we do need an interest-rate and we need a way of setting it as Bank of England Governor Andrew Bailey suggested in a speech last month.

But first to the second important role that central bank reserves play in today’s monetary system: central bank reserves are remunerated at the official policy rate and as such they provide an essential anchor for the implementation of monetary policy.

But that does not mean we have to pay interest on all reserves. For example the European Central Bank introduced two tiers for a while in 2019. It did so for the opposite reason to now (negative interest-rates)  but the principle was established. But it is not clear to me that we can go to zero as we would lose control of interest-rates.

What can we do? Well in his May speech Governor Bailey suggested some numbers we could head to.

But the answers clearly point to a significantly larger balance sheet than we had before the financial crisis, with the latest assessments falling in the range of £345bn-£490bn.

The current level of reserves of around £760bn is still comfortably above this range.

So we could start by trimming some £250 billion of it and then see where to go next. So we could save about a third of what Reform are claiming without much risk to the system and then assess things.

Along the way we see a variety of things and let me remind you I suggested a policy which would have already changed things back in September 2013. Her again is Governor Bailey.

There is a lot of focus at the moment on the cash flows associated with QE and QT. This is understandable given that numbers run into billions. But it is important to note that these cashflows do not measure the overall fiscal let alone economic costs and benefits associated with asset purchase programmes aimed at meeting the inflation target – programmes that reduce borrowing costs, supported the economy through hard times and helped stem deflationary pressures at various points over the past 15 years.

We are back to a word I have not used for a while which is counterfactual. What it means in my financial lexicon for these times is that you should ignore economic difficulties and praise central bankers for their wise and benevolent leadership.

Shaun’s Rule

Establishment accounting follows these rules:

Profits are to be immediately counted even if we do not have them yet.

Losses are to be ignored and if that does not work change the rules until they are gone. In the worst case scenario change their name to assets or put them in a special purpose vehicle.