LONDON, Oct 12 (Reuters) – Raising interest rates before deleveraging huge bond holdings has always risked a financial and political headache for central banks and their governments – and the embattled Bank of England is once again at the center of the brewing storm.
Britain needs another financial conundrum like a hole in the head. But the large maturity mismatch between the central bank’s assets and liabilities after years of balance sheet expansion is now directly linked to excitement over the credibility of government policies, rising interest rates and fears in bond markets.
Furthermore, it could also include the difficult optics of the BoE paying increasing amounts of money directly to commercial banks as it drives up lending rates – while at the same time posting losses that the UK Treasury needs to recoup even as it considers real wages and benefits to fund “Go for Growth” tax cuts.
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A seemingly implicit transfer of funds from the general public to the banks – not unlike Finance Minister Kwasi Kwarteng’s other controversial plan to remove the cap on bankers’ bonuses – could very well continue to anger if a deep recession unfolds.
As investors await the government’s Halloween spending review and long-awaited estimates from its regulator at the Office for Budget Responsibility (OBR), bond investors remain unsettled by the largely unfunded tax cuts and energy stimulus announced last month and how it will do so the inflation of the BoE complicates battle.
The resulting rise in long-term lending rates, compounded by a jolt in domestic pension fund hedging, has forced several rounds of BoE intervention to stabilize the market. And futures now assume that the inflation battle will fall solely on the BoE, expecting it to triple interest rates to as high as 5.8-6% next year.
On Tuesday, the independent Institute for Fiscal Studies said Kwarteng needed £62 billion ($68.22 billion) in spending cuts to keep public debt sustainable over the long term, with borrowing on track for £194 billion this year and still over 100 billion by 2026/27 – over 70 billion higher than OBR forecasts in March.
But – due to rising interest rates, Gilt yields and high repayments on one-third of inflation-protected government bonds – the IFS debt service alone would be more than £100bn this financial year and next – more than £20bn and £50bn respectively above OBR estimates from just six months ago.
Using growth forecasts from Citi, the IFS put that rate bill above 4% of national production for this fiscal year for the first time in more than 40 years. Even if it declines thereafter, it expects to stay well above 2% for the next four years — still well above the average over the past 20 years.
BoE Reserves and Changing Rates Long term Gilt yields are rising
DO NOT MATCH
But the added quirk of the policy comes from how the BoE is being forced to hike interest rates quickly before it can trim its £800 billion-plus balance sheet by a significant amount – the so-called quantitative tightening now being fueled by breaks in the Gilt lagging market and sudden need to buy more gilts this month for financial stability reasons.
Essentially, the issue concerns maturity mismatch due to years of on-off QE programs that have inflated the BoE’s balance sheet since the 2008 bank crash and again since the COVID-19 pandemic – all ostensibly to keep long-term borrowing costs under control.
QE involves buying mainly commercial bank gilts against interest-bearing reserves at the central bank. And unlike other major central banks, the BoE policy rate is itself the interest rate paid on these bank reserves.
All of this is a win-win when interest rates are near zero and bond prices are rising, as the BoE transfers all paper gains to the Treasury – which explicitly compensates for all central bank losses.
But with BoE interest rates rising more than two percentage points to 2.25% over the past year amid the energy shock and inflation surge – and futures markets are now pricing in a rise to nearly 6% by mid-next year – the direct transfer of interest rates to the US is holding up Banks over £800bn in reserves look huge.
Furthermore, the huge bounty of BoE QE that has already flattered financial accounts – more than £120bn up to last year – will dry up as the BoE is likely to realize losses from falling bond values as it sells the bonds and also the payments on bank reserves eventually rise above the coupons they receive on gilt holdings.
Morgan Stanley’s Seth Carpenter points out that central banks can’t go bankrupt, but where balance sheet losses hurt, pointing out that a full point hike in BoE rates would reduce transfers to the Treasury by around £10bn a year – “a significant sum for a country struggling with fiscal problems.”
“The proposal to reduce spending by banning interest payments on reserves deserves consideration,” Carpenter wrote.
The OBR, UK think tank National Institute of Economic and Social Research (NIESR) and others have been spotlighting this looming problem of rising bank reserve payments and BoE QE losses for a number of years.
NIESR last year pushed for a solution to the problem in which the Treasury and the central bank reduced maturity mismatches by swapping longer-dated gilts back into the Treasury to shorten the duration of its portfolios. But that was before interest rates skyrocketed.
NIESR director Jagjit Chadha said questions about stopping or paying only part of interest on bank reserves – which, as overnight floating rate liabilities, account for about 30% of total government debt today – raise thorny questions about “financial repression”, policy transmission through the banks and central bank independence.
“This issue has not been fully grasped by the bank, Treasury or DMO (Debt Management Office) because everyone is worried about stepping on each other’s toes – the kind of problem that falls between the chairs and becomes a crisis leads,” he said.
But he added: “I don’t think these things should be pushed forward – that’s very tricky when you’re thinking about monetary operations.”
IFS Chart on UK Debt Service Payments
The opinions expressed here are those of the author, a columnist for Reuters.
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by Mike Dolan, Twitter: @reutersMikeD; Editing by Josie Kao
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Mike Dolan
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