The Bank of England’s decision to hold interest rates while slowing the pace of quantitative tightening (QT) has put the interaction between monetary policy and the Chancellor’s Budget arithmetic back into focus.
Earlier this month, the Bank of England held rates at 3.75% and slowed the pace of quantitative tightening, as policymakers continue to balance weakening domestic conditions against inflation risks from higher and volatile energy prices. The Monetary Policy Committee (MPC) noted underlying disinflation and labour market loosening are continuing, but stressed the near-term outlook on inflation “remained very sensitive to short-term movements in energy prices.”
The MPC also changed its approach to QT, opting for a slower multi-year path. This means that the asset purchase facility (APF) – which was established during quantitative easing (QE) to purchase large quantities of Government debt bought from the financial sector – will now reduce the pace at which it sells gilts back to the financial sector by around £20 billion annually to 2034, while letting a further £26 billion mature annually to reduce its balance sheet.
The Bank has been offloading its holdings of gilts acquired during QE from £895 billion in February 2022 to £488 billion this month. Under new plans, £222 billion of the portfolio of gilts will be held until maturity, and the remaining £146 billion will be sold back to the private sector.
The change will affect the fiscal outlook through several channels, though Forefront’s James Nation notes the announcement “changes the Bank’s approach to QT but doesn’t really impact the fiscal arithmetic” ahead of the budget.
The OBR will have to incorporate the Bank’s new QT path into its October forecast, with its previous March forecast assuming active sales of £32 billion annually, rather than £20 billion, though it seems unlikely that extra headroom is generated by this.
As the Treasury indemnifies the APF, it bears the financial consequences associated with the portfolio. QE effectively meant that interest payments which previously went to gilt holders remained within the consolidated public sector, as the APF passed its surplus back to the Treasury. However, for the central bank to finance the gilt purchases, it created reserves in the banking sector, which pay the Bank Rate.
When the Bank Rate was very low, the APF generated profits for the Treasury amounting to an estimated £124 billion between 2009 and 2022, as the interest earned on gilts exceeded the cost of the central bank reserves used to finance purchasing them from the financial sector. That position reversed as the Bank Rate rose, leaving the Treasury having to cover losses through its indemnity of the APF as the Bank paid a higher interest on reserves than it received on the gilts it had purchased.
However, if the APF wants to remove these gilts from its balance sheet to eliminate the interest rate loss, it has to sell those gilts. Given the fall in the price of gilts since QE, this means the Bank crystallises losses when they are sold at a lower price than they were purchased at through QT.
The implications of the changes to QT are therefore not uniform in terms of the fiscal rules. The OBR noted last year that interest losses from the spread between gilts and reserves score against the current budget (receipts vs day-to-day spending), while losses that come to fruition once gilts are sold at a loss do not. However, those valuation losses do affect the Public Sector Net Financial Liabilities (PSNFL) measure – the ‘debt’ fiscal rule – also used by the OBR, which takes a broader view of the national balance sheet (debt minus wider financial assets).
To illustrate this, the OBR modelled a scenario last year in which a slower unwind would worsen the current budget deficit by £0.5 billion but leave PSNFL £8 billion lower. The effect of slower QT can therefore move the Government’s two fiscal rules in opposite directions.
There is also a separate effect on the cost of borrowing because the pace of tightening can affect the yield as the supply of gilts grows in the secondary market, lowering their price. The BoE estimated that QT added 20-30 basis points to 10-year gilt rates since 2022, though it stressed high borrowing costs over the period are largely due to other factors. Slowing active sales could therefore reduce some pressure on yields, although the Bank’s estimates do not provide a direct measure of the impact of September’s decision.
The immediate fiscal consequences of the Bank’s new QT path will depend on the effects on gilt yields, the maturity profile of the APF, and the spread between the Bank Rate and gilt coupons, meaning its impact will not be fully apparent before the Budget.
Recent reporting from the Financial Times suggests the OECD believes interest rates are already high enough to curb inflation into 2027 before a 25 basis point cut in Q3 of that year. If borne out, lower rates and potentially lower gilt yields could provide some relief to the public finances ahead of the Spending Review next spring.
For now, however, the Bank has warned that the persistence of the energy shock could require higher rates, while Healey enters the October Budget facing reduced fiscal headroom and pressure to identify further revenue-raising measures.
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