Quantitative Easing, Monetary Policy Implementation, And The Public Finances

14th October 2022

Now interest rates are rising, the interaction of quantitative easing (QE) with the Bank of England's current methods for implementing monetary policy will add to strains on the public finances.

The crux is that QE creates money that goes onto banks' balances (reserves) at the Bank of England, and those reserves are being fully remunerated at the central bank's policy rate (known as Bank Rate). Given the outstanding stock of QE (£838 billion), that has effectively shifted a large fraction of UK government debt from fixed-rate borrowing (where debt-servicing costs are ‘locked in') to floating-rate borrowing (where debt-servicing costs rise and fall with Bank Rate).

Increases in Bank Rate therefore lead immediately to higher debt-servicing costs for the government, leaving the British state with a large risk exposure to rising interest rates, and adding to the already substantial pressures on the public finances. The sums involved are not trivial, potentially running into tens of billions of additional spending on debt interest each year.

Writing for the IFS Green Budget, Paul Tucker examines the nature of the problem, how it has arisen, and the pros and cons of various possible solutions. He argues the current set-up is not technically necessary to operate monetary policy effectively, and so the current predicament could - and arguably should - have been avoided. But as of now, there are no easy options or win-win reforms, with macroeconomic and microeconomic considerations pulling in different directions. The government and the Bank would need to balance several weighty, conflicting things before embarking upon any change.

Key findings
1. Now that interest rates are rising, the interaction of quantitative easing (QE) with the Bank of England’s current methods for implementing monetary policy will add to strains on the public finances. These could, and arguably should, have been avoided by prompt, forward-looking action from around 2019 when the materiality of the risk became apparent (Section 7.2 of main text). As of now, however, there are no easy options.

2. The crux is that QE creates money that goes onto banks’ balances (reserves) at the Bank of England, and those reserves are being fully remunerated at the central bank’s policy rate (Bank Rate). Given the outstanding stock of QE (£838 billion), that has effectively shifted a large fraction of UK government debt from fixed-rate borrowing (where debt-servicing costs are ‘locked in’) to floating-rate borrowing (where debt-servicing costs rise and fall with Bank Rate). Increases in Bank Rate therefore lead immediately to higher debt-servicing costs for the government, leaving the British state with a large risk exposure to rising interest rates. That exposure is not technically necessary to operate monetary policy effectively, so the predicament was not unavoidable.

3. Stepping back, it is a long-standing principle of the UK’s macro-finance framework that government debt management should not impair the effectiveness of the Bank of England’s monetary policy. It would be sensible to add a new precept: that when, in terms of the objectives for monetary-system stability, the Bank of England is indifferent between options for how to implement its monetary policy decisions, it should opt for methods that interfere least with government choices about the structure of the public debt.

4. That high-level principle points towards the Bank reforming the way it operates its system of reserves. In particular, change would be warranted for how the regime operates in circumstances where, because the Bank is conducting QE, the banks cannot choose the level of reserves each wants to hold, but the extra reserves do not squeeze out their investing in other assets. Under those conditions, the principle implies that the Bank should not remunerate the totality of reserves at Bank Rate but only an amount necessary to establish its policy rate in the money markets. In other words, taken on its own, the principle supports the Bank moving to a system of tiered remuneration for reserves balances, combining no (or low) remuneration for some large portion of reserves with a so-called corridor system acting on marginal reserves to establish the Bank’s policy rate in the money markets (explained in Sections 7.4 and 7.5).

5. Such a change would have considerable benefits for the public purse. Given the Bank currently holds around £800 billion of gilts, Britain’s debt-servicing costs are highly sensitive to even small changes in the path of Bank Rate (Section 7.3). Taking current (6 October) market expectations for a substantial rise in Bank Rate together with the Bank’s current published plans for unwinding QE, the implied savings would be between around £30 billion and £45 billion over each of the next two financial years. These are big numbers, and would of course be even bigger if the Bank does not actively unwind QE via asset sales but lets it roll off as bonds mature

6. Assuming the Bank does go ahead with asset sales, the projected savings from moving to a tiered-reserves regime amount to approximately 1.6% of GDP in 2023-24 and 1.2% in 2024–25 (using Chapter 2’s Citi forecasts). They would, therefore, reduce prospective annual debt-servicing costs from around 3.9% to around 2.3% of forecast GDP in the first year, and from around 2.7% to 1.5% in the second (using Chapter 3’s IFS forecasts). Put another way, if not implemented, the forgone annual saving of (on average) £37 billion over the next few years would be equivalent to around 9% of recent annual spending on health, education and defence.

7. What might seem at first sight like an obvious easy-win reform needs, however, to be balanced against a number of other important considerations. They concern the effects of bank taxes on allocative efficiency, and on credit conditions (Section 7.6); and, separately, central bank credibility (Section 7.7).

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