There’s an extra £40bn of lost fiscal space lodged behind the government’s budgetary sofa

As of the 2024 general election, Reform UK is the sole parliamentary player looking at ‘reforming’ the way the Treasury makes payments to the Bank of England. 

Say what you will about Nigel Farage, but this is quite a smart move. I wouldn’t call it a stroke of genius per se, but after reading both the Tory and Labour manifestos, I’m surprised that neither party wants an extra £40bn to play with

But I digress. This isn’t an article about politics, it’s about the different ways in which we could alter the Bank/Asset Purchase Facility (APF) x Treasury relationship to find some fiscal space (and clear out some junk while we're at it). 

Let’s start with Nigel, what is he saying? 

First off, it’s probably a good idea that you have a sound understanding of where Nigel’s £40bn figure comes from. The long explanation can be found here but if you want to stay, I’ll try my best to keep you in the loop. 

Reform’s proposal is as follows: put an end to active QT. What does this mean? It means that the Bank will stop actively selling government bonds and will instead allow them to reach maturity. Why will this save money? It will save money because when the Bank actively sells its bonds, it suffers an APF valuation loss. Why? Because APF valuation losses stem from the fact that bond prices fall when interest rates are high. For COVID-era bonds, which were issued when interest rates were very low, this valuation loss comes from the difference between the original (high) bond price and the new (low) price. Hence, this is a pretty bad time - fiscally speaking - to start selling government bonds. 

Reform proposes an end to this active sale which they claim will save the taxpayer £40bn. The key part here is that the Treasury will still have to pay for an APF interest loss. What is it? The APF interest loss stems from the fact that the Bank of England’s Asset Purchase Facility has a bank-rate loan with the Bank of England that it must repay. When the interest rate on this bank loan is higher than the interest rate the APF earns on its bonds (which is what is happening right now) it makes a loss. 

Farage’s and Reform’s logic is as follows: waiting for bonds to mature is better than active sales as we can wait for interest rates to fall (they probably will), making the APF interest loss materially lower and saving the taxpayer billions. 

Smart, but not genius. Reform’s proposal greatly undermines central bank independence. The Bank isn’t performing active QT just for the hell of it. It’s doing so to achieve its internal objective of meeting a Preferred Minimum Range of Reserves (PMRR). 

While a new(ish) term in the central banker's lingo, the PMRR just means that the Bank of England wants to reduce the number of reserves down to a level where there is just enough money to go around. The Bank acts as the bank for banks. Just like we do in our bank accounts, commercial banks can hold deposits (reserves) at the Bank of England. Here, the Bank remunerates these reserves at the current bank rate to set a floor for interest rates (no commercial bank would try to beat the Bank at its own game). 

This remuneration is not an issue when the bank rate or quantity of reserves is low, but when both are high running a central bank becomes very expensive all of a sudden

This is the situation we find ourselves in (we’re here thanks to a decade of QE that has led to a large accumulation of reserves, thanks QE). QT is now trying to reverse this. However, even that is costly. Commercial banks are also fighting back as they fear losing that sweet remuneration nectar. 

This looks like a lose-lose situation, but there is a way out, and that’s through the introduction of tiered reserves

TLDR; the Bank’s decision to remunerate all reserves is historically (and relatively) unusual. Our European neighbours at the ECB use tiered reserves where different levels of reserves are remunerated at different rates. Here, the Bank could, hypothetically, announce tomorrow that they will no longer be paying any interest on excess reserves. This could be reserves beyond the PMRR or maybe £895 billion (the value of reserves generated via QE).

To understand why this would save the Treasury some dough, consult this very helpful chart from the FT:

The bank rate loan between the Treasury and the APF is valued at the quantity of reserves at the bank rate. This insulates the Bank’s balance sheet from profits and losses made from QE/QT. In other words, if we switch to a tiered reserve system - choosing to not remunerate QE reserves (as an example) - the interest on the bank rate loan to the APF would be zero and would be a quick way of reducing APF ‘interest losses’ for the Treasury. 

This approach would be a lot better for retaining central bank independence and would also save a lot of money. That being said, there are still a few caveats. A small one is that the introduction of a tiered reserve system would switch us from a ‘floor’ system to a ‘corridor,’ where short-term interest rates can be subject to fluctuation, but this isn’t an issue on its own. 

The problem lies in picking the correct size of a tier and its remuneration. While I use choosing not to remunerate QE reserves as an example, this is probably a bad idea. Such a high quantity of unremunerated reserves would lead to higher interest rate volatility and financial stability risk. If reserve remuneration acts as a floor, and commercial banks are not happy with the floor, they will either rely on the Bank’s lending facilities (which in turn drives up the cost of borrowing) or private means such as the interbank lending market (which is a sure as fast way of spreading financial contagion). 

The antidote to this is to be sensible. Should the Bank switch to a tiered system, it should pick the corresponding size and remuneration of reserves by slowly testing the waters to see what markets want. The end product will be a reduction in APF interest losses for the Treasury as well as better performance for monetary policy.

“But what about the APF valuation loss?” I hear Farage calling. 

Oh, that’s right, the QT bill is heavily weighted towards valuation losses. Reserve tiering is unprepared to deal with this, but don’t worry, we don’t have to side with Farage. There is still a place for tiered reserves. 

We can make space for tiered reserves by clearing out some unnecessary junk that complicates the way the Bank of England does QE and QT. Remember that indemnity agreement that requires the Treasury to pay the APF if it makes a loss? Yeah, we can just scrap that. 

While this sounds quite radical, it really isn’t it. It’s exactly what the Fed does. The Bank of England, being the central bank, cannot ‘run out’ of its own currency. So, when the APF makes a loss, it can just ‘defer’ that loss on its balance sheet and run at negative equity. Then, it just waits until it starts making a profit again and uses these profits to pay off the deferred asset. Eureka, no Treasury and taxpayer money needed. 

By combining a tiered reserve system into this new arrangement, the Treasury would pay nothing, and through a lower APF interest loss, the Bank would have a smaller deferred asset to pay off. A spring clean of this sort would give us three really big wins. A win for central bank independence, Treasury coffers, and the taxpayer's pockets. 

Oh, and if you want to use this as a win, it also puts Farage’s proposal on the back burner.


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