No great expectations

The costs of BoE's APF and how not to address them

“… at the rate of that handsome sum of money per annum, and at no higher rate, you are to live until the donor of the whole appears.” Great Expectations

Charles Dickens obsessed over the problems that accompanied debt. In novel after novel the misery of debt and its costs form the foundation of his tale. A potentially expensive bill from the Bank’s QE programme has started to generate some creative storytelling of its own about how the Bank can avoid misery from its own debts.

The NIESR recently reminded us of its own suggestion from last year that the BoE swap reserves for bonds, which would somehow save money. It’s not clear how that would work. Why would banks need to be asked to buy more bonds from the Bank when they could switch into government bonds whenever they wished? Nor is it clear if the proposal would be legal.

A much simpler proposal comes from the optimistically named New Economic Foundation, which argued the cost of Interest on Reserves should be reduced by (drumroll) not paying any interest! It’s an approach that UK mortgage holders may wish were available to them as interest rates rise. Sadly, for mortgage holders, interest rate rises mean they will just have to pay more to the banks whose money they borrowed.

Luckily the Bank isn’t like most mortgage holders. The Bank has an indemnity from the Treasury for all losses on the APF, signed by George Osborne in November 2012.  In return, the Treasury snaffled any profits. Indeed, at the current Bank Rate of 1.25%, the Treasury can look forward to a stream of profits for a few years yet.

So, the Bank and the Treasury are in the clear? Well, not quite. If Bank rates rise to 2% these profits turn to clear losses. At that rate the costs of the APF portfolio will exceed the combined capital plus coupon income. Mr Osbourne’s letter explicitly acknowledged possible future losses. “I am happy to reaffirm my predecessor’s commitment that any future losses incurred by the APF will be met in full by the Government.” This isn’t the Bank’s problem, it’s the government’s problem. Why does commentary focus on the Bank? Because it is the Bank’s reserves that funded the APF, that generate the loss, that George Osborne signed for. Clear? Not exactly.

Two percent interest rates are not especially high. The Federal Reserve forecasts US short-term rates will rise to 3.4% by year-end and rise further in 2023. If the Bank of England was forced to follow a similar path, the losses on the APF for the Treasury would be eye-catching (and eye-watering). It’s no surprise that a left-of-centre think-tanks would like to avoid government resources being diverted from education or health (or defence) to banks via the indemnity. Unfortunately, this is what the government signed up for.

Even if we can navigate the moral/legal duty that accompanied the Treasury indemnity, a number of difficulties arise from the NEF proposal. For brevity, let’s just consider two issues (one technical and one institutional) that arise from the NEF’s magic-money tree creative proposal.

The technical issue arises from how monetary policy operations changed under QE. In the old days (pre-QE), the Bank did not pay interest on reserves because it did not need to. At least part of the incentive behind the NEF proposal appears to be an innocent longing for a return to this prelapsarian simplicity. Pre-QE, the quantity of reserves in the system were small and largely comprised Required Reserves banks were forced to deposit. In that world, the Bank operated a ‘liquidity shortage system’ with regular auctions to alleviate liquidity demand using the Bank Rate as the interest rate. That meant monetary policy was delivered via the Bank Rate as a floor for UK interest rates.

The Bank’s Quantitative Easing programme turned that system upside down. From a system relying on liquidity shortage, the Bank shifted to a policy of ‘all you can eat’ liquidity as reserves were issued to pay for the APF assets. With so many reserves flooding the system a ‘shortage system’ was impossible. The only way to create a floor in interest rates was to pay interest on those reserves. If the Bank was to remove interest on those reserves, as NEF suggests, money market rates and deposit rates would collapse at a time when Andrew Bailey is attempting (admittedly rather timidly) to increase interest rates. Monetary policy would be undone. The likely effects on sterling don’t bear thinking about.

The institutional issue arises from the odd omissions from George Osborne’s letter of indemnity of how the Bank and the Treasury delegated responsibilities. While there is lots of talk of assets, transfer of profits, guarantee of future losses, there is no mention of how the operations of the Bank would be affected. The Treasury indemnified the APF but left monetary policy, including matters related to reserves, in the hands of the Bank. The NEF proposal seems to have noticed this unfortunate split in responsibilities and decided the Treasury can take the upside but delegate the losses to the funders of the project - the Bank. Many a bankrupt has attempted a similar separation of liabilities from assets, but it is hardly the best advice to offer a central bank.