Mike Dolan

LONDON, (Reuters) – Markets are primed to see a Bank of England rate increase as early as next week. However, UK policymakers face an unpleasant entanglement of monetary policy and fiscal policy, bequeathed through central bank bond purchases, also known as ‘quantitative easing’.

Rishi Sunak, UK’s finance minister, presents his most recent government budget Wednesday. He is likely to be relieved that borrowing estimates are lower than originally forecasted after the pandemic. However, he also has to provide a framework for stabilising medium-term public finances.

But, money markets have been influenced by the BoE’s rhetorical turn over the last month to predict a rise in 0.1% of the historically low policy rate by yearend due to rising inflation expectations. This opens up a long-running discussion about the vulnerability of UK government debt to rising rates.

British Government’s Office for Budget Responsibility is the watchdog for budgets. They have been highlighting the problem throughout the year.

The Treasury is exposed to high short-term interest rates, which raises concerns about central bank autonomy. Although the BoE has been operationally independent from the government since 1997, it still reports to Treasury. Treasury also sets its inflation target.

Problem is, in essence, the maturity mismatch that has resulted from years of ongoing QE programmes. These have helped to lift the BoE’s financial position since 2008 banking crisis and then again since pandemic.

The purchase of most gilts from banks is QE. This allows the central bank to earn interest on the reserves, rather than just cash. To adjust its overall monetary policy, the BoE relies on the floating interest rates of those bank reserve funds to determine the ‘Bank rate’.

A trillion-dollar balance sheet and a rising short term interest rate can cause problems both for the central bank as well as government.

This was a win/win deal as interest rates dropped. The central bank receives less interest on reserves than on longer-term debts, which means that debt servicing costs are capped. This is a huge win for them. These profits were returned to Treasury.

OBR estimates that, to date, positive cash flow from the Bank of England’s Asset Purchase Facility to Treasury was 113 billion pounds ($156 trillion).

However, all of that is thrown off balance when the Bank Ratio starts to rise. It will likely be faster than long-term rate and more so if it were to reverse. All BoE losses will be covered by Treasury.

UPSIDE DOWN

OBR believes that by 2013, nearly a third (or 875 billion) of gross public debt ($1.2 trillion USD) will be in bank reserves. The Bank Rate is nine times more than what it was today, according to market pricing. This rises to approximately 90 basis points (from 0.1%).

One percentage point of interest rate rise across all the ranges on consolidated liabilities of public sector entities would cost half a percent GDP in 12 months.

The implication of this is that, instead of having outstanding gilts with a median maturity exceeding 14 years at the G7, the median maturity for consolidated public debts is just 2 years. This makes them very dangerous during prolonged interest rate increases.

OBR says that this scenario, along with the fact about 25% of UK government debt has been inflation protected, means that a sudden burst in inflation doesn’t have the same positive impact on debt ratios as it did several decades ago.

VoxEU published this week an article by Charles Goodhart and Manojpradhan, who wrote a 2020 book that argued for structural inflation revival. They said central banks must be aware of sudden and potentially destabilizing policy changes to maintain credibility.

However, they caution that large central bank balances in an era of rising interest rate raises political questions regarding the payment of commercial banks greater and larger returns and about what Bank policy means for Treasury.

Their words were: “At an age of worsening credit service ratios the need for higher taxation, and the transfer from the public purse of increasing payments to commercial banks in order to hold reserves at the central banking will become more politically unpopular.” This conjuncture can be difficult to defend, even if you are not a populist politician.

Pradhan and Goodhart said that central banks would have to take capital losses from their holdings, and may need recapitalization by governments. The process should not be questioned about the independence of central banks.

There are solutions. The National Institute of Economic and Social Research, an independent UK think tank, has stated that Treasury and the central bank need to decrease the maturity mismatch. Treasury should swap longer-dated gilts to Treasury in order to shorten its portfolios.

Their proposal “aims to limit even a slight appearance of conflicts among the Treasury and Central Bank when macroeconomic policy has to tighten,” the authors wrote.

(by Mike Dolan. Twitter (NYSE): @reutersMikeD