lnstitute for Fiscal Studies
Quantitative easing,
monetary policy
im
plementation and
the public finances
IFS Report R223
Paul Tucker
IFS Green Budget 2022
1
7. Quantitative easing,
monetary policy
implementation and the
public finances
Paul Tucker (Harvard Kennedy School)
1
,
2
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
1
Sir Paul Tucker is a research fellow at the Harvard Kennedy School’s Mossavar-Rahmani Center for Business and
Government; is author of Global Discord (Princeton University Press, November 2022) and Unelected Power
(Princeton University Press, 2018); is President of the National Institute of Economic and Social Research; and is a
former central banker who, among other things, worked at various times on monetary policy, monetary operations,
government debt management and prudential policy.
2
With special thanks to Ben Zaranko (IFS) for active assistance and comments. Thanks also to Carl Emmerson and
Paul Johnson (both IFS), who usefully pressed the importance of clarifying various things for readers outside the
monetary policy community; to Steve Cecchetti for comments on an early draft; to my former central banking
colleagues Peter Andrews and Roger Clews, with whom I worked on debt management strategy and reforming
debt-management operations during the mid 1990s, and on overhauling the Bank of England’s monetary operations
then and, again, in the mid 2000s; to David Aikman, Paul Mizen and John Vickers for exchanges on the section on
banks; to Stefanie Stantcheva, Jeremy Stein and Larry Summers for exchanges on public-finance economics; and
to Charlie Bean and Mervyn King for going through a near-final draft.
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(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,
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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).
8. The first and second of those arise because the counterpart to the state’s debt-
interest savings would be lower interest payments from the Bank to the banking
industry on its reserves balances. This could be regarded as a tax on banking and
one, moreover, that might depart from standard public-finance-economics prescriptions
on the tax system not distorting incentives and being stable over time. The broad point
– and the key high-level trade-off – is that in deciding whether to ask the Bank to
consider moving to a tiered-reserves system, the government would have to balance,
on the one hand, suboptimal taxes being imposed today (to avoid the higher borrowing
brought about by a suboptimal debt structure) and, on the other hand, accepting higher
borrowing today (to avoid imposing inefficient taxes) and accepting the prospect of
having in the future to impose higher taxes (on incomes and consumption) and/or cut
the provision of public services. Broadly, this pitches microeconomic considerations
against macroeconomic ones.
9. The standard prescription would be to accept the latter course: do not introduce
inefficient taxes when better solutions can be applied over time to the macro problem.
The better choice might, however, be affected by whether, in current and prospective
circumstances, government might have to pay a default-risk premium on bond-market
borrowing unless it cuts the near-term deficit; and by whether more broad-based tax
increases and/or cuts in public services are politically infeasible or socially undesirable.
10. There is also a question of whether a tiered-reserves scheme is best regarded as
introducing a tax on banking intermediation or, alternatively, as withdrawing a
transfer to banks’ equity holders and managers; crudely, a distinction between
banking and bankers. If competitive conditions in banking are such that, as Bank
Rate rises, the benefits of fully remunerated reserves would be passed on to neither
depositors nor borrowers, but instead would go straight into banks’ profits, then
perhaps full remuneration of reserves is better regarded as a transfer. But even if UK
banking were uncompetitive (on which we do not take a view), it does not follow that
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Quantitative easing, monetary policy implementation and the public finances
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there would be no (or only small) pass-through of higher Bank Rate to banks’
customers.
11. Quite apart from government needing to weigh allocative efficiency in the economy
against its debt burden, the Bank of England would separately need to form its
own view on whether withdrawing a flow of income from reserves would hurt the
resilience of the banking system; and also whether the macroeconomic effects
of any tightening in loan conditions could be offset by monetary policy.
12. In addition, the authorities would need to weigh some political economy risks.
One is the possibility that unremunerated reserves would make QE an attractive
source of funding for government, which might warrant higher hurdles in the
way of routine monetary financing. Another is that changes in the reserves regime
might dent perceptions that the Bank’s operating framework will be stable over time, so
any new regime needs to be designed to work well in many different states of the
world.
13. Given the need to balance many different considerations, and given the Bank has
private information on the state and choices of the banks, this chapter falls short of
recommending that the reserves regime be changed right now. But nor does it rule out
early reforms. It is clear, moreover, that, unless the Treasury objects on tax-
efficiency grounds, the Bank should set out how it will operate a reformed
system in future. The prospect of the current predicament recurring is not
hypothetical. Given many current estimates of the equilibrium global real rate of
interest are close to zero, the lower bound for the UK’s Bank Rate is likely to bite, and
so QE be deployed, much more frequently than when the UK’s current monetary policy
regime was established.
14. Finally, the broad principle discussed above – that the Bank should, where consistent
with its mandate, adopt methods of monetary policy implementation that interfere least
with public debt management – might be thought also to have some bearing on
how the Monetary Policy Committee (MPC) chooses to tighten monetary
conditions to get control of inflation. Specifically, if the authorities believe gilt yields
currently incorporate a default-risk premium but that it will unwind, it might be argued
that, on debt-management grounds, the MPC should defer selling gilts (quantitative
tightening, or QT) in order to avoid the state paying the risk premium for the residual
term of the sold bonds, instead relying entirely on raising Bank Rate to deliver its price
stability objective. We believe, however, that the better conclusion is that if the
authorities did want to avoid locking in such costs, any adjustment in the pattern
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of government funding should come in the maturity structure of new issuance
by the UK’s Debt Management Office.
15. That being so, it is important that the significance of this chapter’s central dilemma –
between the debt burden and allocative efficiency – would be reduced by early QT
sales, since they would shrink the quantum of reserves held by banks with the Bank
(whether or not the reserves scheme is reformed).
16. In conclusion, if, as argued here, the Bank’s monetary techniques have distorted the
British state’s debt structure in unfortunate ways, it matters that the simplest remedy
might introduce tax-induced distortions to the allocation of resources. Balancing those
conflicting considerations in current circumstances is a weighty matter for
government. This chapter aims to frame the debate. If, having balanced the different
considerations, the government were to ask the Bank to consider whether reforms
could be introduced without compromising monetary policy, we believe the Bank would
need carefully to analyse, and consult on, the implications for price and financial
stability. But subject to the government exercising a veto on inefficient-tax grounds, we
are not ruling out reforms to the reserves regime for periods when QE is being
deployed.
7.1 Introduction
There has been growing concern about the effect on the public finances of the government
having effectively borrowed at a floating rate of interest, which will increase, possibly sharply,
as the Bank of England tries to bring inflation under control. Higher debt-servicing costs would
increase government borrowing, and would imply, eventually, some combination of higher taxes
and lower spending on public services and other things. This predicament is a complicated
product of low equilibrium market interest rates, the authorities’ resorting to quantitative easing
(QE) as a substitute for interest rate cuts at the zero lower bound, and central banks paying
interest on banks’ reserves. That cocktail of technicalities needs some slow-motion unpacking in
order to expose the nature of the problem and the pros and cons of various possible solutions.
This chapter aims to do that.
To begin with a sweeping summary, we can say the following. When a central bank purchases
government bonds, it leaves the size of the state’s consolidated balance sheet (see annex for
definitions) unchanged, but alters the composition of its liabilities. When the central bank pays
interest on the money it created to buy those bonds, it changes the profile of interest payments
on the state’s consolidated debt, which might turn out to be costly, cheap or neither. There are
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Quantitative easing, monetary policy implementation and the public finances
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good reasons to think that UK government debt-servicing costs will be much higher than they
otherwise could have been, plausibly running into many tens of billions of pounds.
3
While this
has become more obvious since the Bank of England’s policy rate started rising, the risk existed
even during the period when QE was running a profit (because the policy rate was very close to
zero). Proposals for reform have included the Bank of England stopping paying interest on
banks’ reserves, and government partially hedging the exposure. In order to explain what is
going on, it is necessary to look at the mechanics and economics of how QE interacts with
public debt management, the economics of various options for attenuating the link, and some of
the background political economy dilemmas.
From a macroeconomic-policy perspective, a lesson that emerges for the future is that when a
central bank’s monetary policy significantly employs QE, it should not remunerate all the
reserves held by the private sector but only whatever fraction of reserves needs to be
remunerated to establish its policy rate in the short-term money markets. Even if there were
reasons to hold back from immediate reform, this implies reforming the Bank’s operating regime
after the current stock of QE has unwound but before QE is employed again. But a series of
microeconomic policy considerations, belonging more to the Treasury than the Bank, also need
to be weighed. So the issue is not straightforward, but it is big – because the implications for
government borrowing are big.
The chapter begins with how the risk exposure in the public finances has arisen and in what
circumstances it matters (Section 7.2), followed by a range of estimates of the exposure’s
quantitative significance (Section 7.3). It goes on to explain why central banks moved to paying
interest on reserves (Section 7.4), and whether the current set-up is the only one that can
reconcile quantitative easing with control over short-term interest rates (to jump ahead: no). It
then outlines, for purposes of exposition rather than recommendation, how monetary policy
might operate if interest were not paid on the bulk of reserves (Section 7.5). Having explained
the obvious attractions of reforming the Bank’s reserves regime, the chapter turns to
microeconomic considerations, setting out some that would need to be carefully weighed against
any more macro benefits to the public purse. These concern the effect of taxing banking on the
efficient allocation of resources, and on pass-through to customer loan and deposit rates (Section
7.6); and, separately, central bank credibility (Section 7.7). Before concluding, two alternative
strategies are briefly noted: hedging part of the exposure, and the Bank relying on selling off its
gilt portfolio, rather than increasing its policy rate, when it wishes to tighten monetary
3
This risk exposure was highlighted in evidence to the House of Lords Economic Affairs Committee hearings on
QE by Philip Aldrick and by Paul Tucker on 2 February 2021, and was picked up in the evidence of Charles
Goodhart and Adair Turner on 16 March 2021 (https://committees.parliament.uk/work/993/quantitative-
easing/publications/oral-evidence/). It is discussed in paragraph 141 of the committee’s report
(https://committees.parliament.uk/publications/6725/documents/71894/default/) and, later, in the July 2021 fiscal
risks report of the Office for Budget Responsibility (2021b).
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conditions (Section 7.8). After recapping how its main findings relate to public risk management
and accountability, the chapter draws to a close by suggesting a new principle to help guide the
interaction of monetary policy and public debt management.
7.2 Central banking and the public finances:
qualitative analysis
Central banks’ financial operations affect their countries’ public finances in a very direct way. A
central bank is a machine for issuing the money that is the final settlement asset in a monetary
economy – known to economists as base money (see annex). It alters the amount of this money
circulating in the economy via financial operations of various kinds. Those operations change
the structure and/or size of the state’s consolidated balance sheet.
If a central bank buys only government paper, the structure of the state’s consolidated liabilities
is altered, but its size is left unchanged because one organ of the state (the central bank) has
bought the liabilities of another (central government). Monetary liabilities are substituted for
government’s longer-term debt obligations. If, by contrast, the central bank purchases private
sector paper or lends secured or unsecured to the private sector, the size of the state’s
consolidated balance sheet increases, with monetary liabilities being added to the government’s
outstanding debt, and in addition the risk structure of the state’s consolidated asset portfolio
shifts.
4
In each case, it matters whether the central bank pays any interest on its monetary liabilities, and
at what rate of interest. For around 20 years (as explained in Section 7.4), the main central banks
have paid interest at or close to their policy rate on reserves balances held by banks; the Bank of
England pays its policy rate, known as Bank Rate (defined in the annex, and shown for the
period since Bank of England independence in Figure 7.1). In consequence, when the central
bank purchases government bonds – via what is known as quantitative easing or QE – there is an
effect on the public finances. Whatever its utility for monetary policy (not discussed here), the
combination of QE and interest-on-reserves is roughly equivalent, for the public finances, to the
Treasury department entering into a debt swap with the private sector via which fixed-rate
government debt is swapped for floating-rate obligations. This means that rather than locking in
the rate of interest it pays to borrow, the state pays a rate of interest that is reset each time –
4
Some of the Bank of England’s recent facilities have done this; notably, the Term Funding Scheme (TFS), under
which there is currently nearly £200 billion of loans (with an original term of four years) outstanding. The TFS
does inject additional reserves. But because TFS loans are charged Bank Rate (plus a premium), the interest-rate
structure of the state’s consolidated debt is not affected. (The state does take credit risk under this and various other
schemes and facilities introduced during COVID and in response to the energy price shock.)
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Quantitative easing, monetary policy implementation and the public finances
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roughly every six weeks – the Bank of England decides its policy rate, and so goes up or down
when Bank Rate goes up or down.
For the UK, so long as the state’s sovereign creditworthiness is not in question, the implications
for the public finances of long-lived QE are most easily examined in terms of the state’s
expected and realised debt-servicing costs (i.e. ex ante and ex post) rather than any volatility in
the mark-to-market value of the QE gilt portfolio.
5
The state is not liquidity constrained – not
least because the Bank can create money provided it maintains credibility for low and stable
inflation – so the state can finance itself through any nasty volatility in the value of its asset
portfolio.
6
Until and unless QE is unwound by selling bonds (Section 7.8), the state’s notional
mark-to-market gains and losses are typically not realised because, ordinarily, government does
not trade in its own debt or buy back bonds before maturity.
Figure 7.1. Bank Rate since Bank of England independence
8
7
6
5
Per cent
4
3
2
1
0
May 97
May 98
May 99
May 00
May 01
May 02
May 03
May 04
May 05
May 06
May 07
May 08
May 09
May 10
May 11
May 12
May 13
May 14
May 15
May 16
May 17
May 18
May 19
May 20
May 21
May 22
Source: Bank of England.
5
Had QE been short-lived, with all bonds sold before they matured, that would not be so. Instead, any capital losses
on its succeeding in helping to revive the economy would, in those circumstances, have had to be weighed in the
balance against the broader welfare benefits (including via higher taxes and lower welfare spending) of the
economic recovery that was driving up yields. It remains the case that the Bank enjoying a cash-flow profit (loss)
in the first years of a gilt holding is something neither to celebrate nor bemoan as it might be offset over the
remaining period of the holding. It is the profit/loss up to the point of maturity or sale that matters to evaluating the
effects on the public finances (see Section 7.3).
6
The conditions under which this can be consistent with maintaining central bank independence, and so anchored
inflation expectations, lie beyond the scope of this chapter.
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While this can be obscured by the complex arrangements between the Bank and HM
Government (HMG) for conducting QE – involving an Asset Purchase Facility (APF) booked to
a special purpose vehicle, an indemnity and other things (Box 7.1) – what matters to taxpayers is
the position where Bank–HMG transfers are netted out, leaving only the state’s net transactions
with the market. By introducing a couple of simplifications, this becomes clear. If we assume
that the Bank holds the gilts it buys until maturity and that it buys new gilts at the yield at which
they were issued into the market (a reasonable approximation for 2020–21),
7
the financial effect
of QE on the state’s ex post debt-servicing costs – positive or negative – is simply equal to the
Bank’s cumulative profit or loss from buying and holding a long-term bond and financing it by
borrowing at Bank Rate. If, therefore, over the life of the bond, Bank Rate averages the yield at
which the bond was issued (and purchased), QE does not materially affect the public finances. If
Bank Rate is on average higher than that yield, the Bank makes a loss, which it passes on to the
Treasury, and so the state would have financed itself more cheaply if the Bank had not bought
the bond. Conversely, the state saves money if Bank Rate averages below the yield on the bond.
8
Box 7.1. The Asset Purchase Facility vehicle
The Bank of England implements QE via a special purpose vehicle called the Bank of England Asset
Purchase Facility Fund Limited (APFF Ltd). The company is a fully-owned subsidiary of the Bank.
When the vehicle purchases gilts, it finances the purchases by borrowing from the Bank’s Banking
Department, which charges a rate of interest set at Bank Rate. The reserves created are liabilities of
Banking Department. So in double-entry bookkeeping terms, Banking Department’s liabilities increase
by the amount of reserves created and held by banks, and its assets increase by a loan to APFF Ltd of
exactly that amount. Both liabilities and assets pay Bank Rate, so Banking Department has no interest-
rate exposure.
Meanwhile, APFF Ltd has a debt liability to Banking Department costing Bank Rate, and assets
comprising the gilts bought as part of the QE operations. The APFF Ltd therefore has an exposure to
interest rate risk: it has borrowed at a floating rate, and invested in a portfolio of fixed-rate securities.
The Treasury indemnifies APFF Ltd against any losses incurred via that exposure, and it receives any
running profits (when Bank Rate is lower than the average yield on the APF portfolio).
a
It was initially
envisaged that there would be a settlement of any profits or losses at the end of the QE scheme. But in
7
This effectively assumes (a) that there are no transaction costs in HM Treasury issuing into the primary market and
the Bank buying shortly afterwards in the secondary market and (b) that the price has not moved in the time
between the two transactions. During QE’s initial phase, during 2009–10, the Bank was not especially buying new
gilts, so any capital gain or loss on holding to maturity matters too.
8
That does not imply, however, that in such circumstances all issuance should be at short maturities in order to save
the term premium. See main text below.
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Quantitative easing, monetary policy implementation and the public finances
late 2012 it was announced that quarterly cash settlements would be introduced as QE was not winding
up on anything like the timescale envisaged.
b
Securities bought and held by the vehicle are, for accounting purposes, marked to market (MTM). Any
MTM gains or losses are offset by changes in the accounting value of amounts due to or from the
Treasury under the HMT Indemnity since that too is valued on an MTM basis (note 8 to BEAPFF
2020–21 accounts).
Figure 7.2. Cash flows to and from the Asset Purchase Facility
Source: Adapted from Bank of England, Cash transfers between BEAPFF and HMT,
https://www.bankofengland.co.uk/-/media/boe/files/markets/asset-purchase-facility/cash-transfers.pdf.
a
The indemnity is best thought of as an instrument of political economy designed to make clear up front to everyone,
including parliament and the public, that any Bank losses would fall on the Treasury. In fact, under the UK system,
that would have been so anyway, but might not have been widely understood.
b
Confirmed on page 4 of the BEAPFF Annual Report and Accounts for 2020–21. Quarterly cash settlement mirrors
long-standing arrangements for the Bank’s Issue Department (to which pound-note liabilities are booked). The Bank
was split into Issue Department and Banking Department in 1844 by legislation introduced by Prime Minister Peel.
The risk exposure
As the above makes clear, since QE combined with remunerated reserves shifts the state’s
consolidated liability structure, it obviously alters its exposure to risk, where risk is conceived of
as uncertainty about the path and the net present value of the state’s debt-servicing costs. The
incremental risk exposure is greater the larger the stock of QE, and risks are more likely to
crystallise the longer the exposure lasts. In fact, of course, QE has ended up being very much
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larger and much longer-lasting than envisaged back in 2009–10. The stock of QE rose from
£200 billion at end-2010 to £435 billion at end-2019 and £875 billion at end-2021 (Figure 7.3).
9
Figure 7.3. Cumulative gilt purchases via the Bank of England Asset Purchase Facility
£200bn
£375bn
£435bn
£875bn
0
100
200
300
400
500
600
700
800
900
1,000
£ billion
2009 Jan
2009 Jul
2010 Jan
2010 Jul
2011 Jan
2011 Jul
2012 Jan
2012 Jul
2013 Jan
2013 Jul
2014 Jan
2014 Jul
2015 Jan
2015 Jul
2016 Jan
2016 Jul
2017 Jan
2017 Jul
2018 Jan
2018 Jul
2019 Jan
2019 Jul
2020 Jan
2020 Jul
2021 Jan
2021 Jul
2022 Jan
2022 Jul
Note: Figures show purchases of gilts only and exclude approximately £20 billion of corporate bonds
purchased by the APF.
Source: Office for National Statistics series FZIU (BoE: Asset Purchase Facility: total gilt purchases: £m
CPNSA).
It is natural to think of the risk exposure in terms of the uncertainty that arises from the structure
of the state’s debt stock veering away from what analysis had suggested would be sensible
absent QE. Had fiscal stimulus, not monetary stimulus, been the favoured instrument for
promoting economic recovery from the middle of the 2010s, the annual deficits would have been
larger but the structure of the state’s debt would presumably have been broadly unchanged
(given a stable debt-management strategy for many years).
Government’s choice of debt structure in normal conditions should be based on analyses of the
pattern of shocks – their type and possible scale – that might plausibly hit the economy. That
entails assessing the prospective effects on tax revenues and spending of a wide range of shocks,
taking account of whether different types of gilt issuance provide insurance to the private sector
9
These numbers are for QE via the purchase of gilts. The Bank’s operations to buy corporate securities raise
different issues, and are not considered here.
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Quantitative easing, monetary policy implementation and the public finances
and so dampen or amplify the transmission of shocks. Given the shocks might be nominal (e.g.
to the credibility of the monetary regime) or real, and that those real shocks might be to demand
(e.g. to consumer tastes) or supply (e.g. to technology), and sourced either domestically or
externally (notably, an energy price shock), the standard choice – certainly in the UK – is to
issue both nominal bonds and inflation-indexed bonds spread across the maturity spectrum.
10
More plainly, it makes sense to avoid effectively betting, via a lopsided debt structure, on certain
types of shock never occurring.
That, in its direct effects, is what swapping the debt into floating-rate nominal liabilities amounts
to for the public finances. The Bank of England’s QE operations purchased only nominal bonds,
not inflation-indexed bonds.
11
From the perspective of debt management, those purchases
accordingly undid HMG’s favoured duration choices for nominal issuance, while leaving the
nominal/indexed split of the public debt unchanged. This meant, among other things, that in the
face of a positive shock to domestically generated inflation that monetary policy did not pre-
emptively offset, debt-servicing costs would be hit by both a permanent increase in the cost of
servicing inflation-indexed bonds, and a temporary increase in the Bank Rate paid on reserves
when monetary policymakers caught up (a risk that is crystallising currently). We assume here
that the authorities were right to exclude inflation-indexed bonds from QE as that left the British
state with its (deliberate) exposure to rises in inflation, and so left intact the incentives for the
Treasury to favour low and stable inflation, and thus to maintain a strong, independent central
10
Even with a positive term premium (see annex), it is prudent to spread issuance across the maturity spectrum, as
bunched short-term issuance exposes the state to rollover risk (adverse price terms, or even quantity rationing) if
circumstances deteriorate; the UK has typically chosen to issue a higher proportion of its debt at long maturities
than its peers. The richest versions of such ‘optimal’ debt-portfolio studies seek to take into account the effect of
different types of shock not only on debt-servicing costs but also on government tax receipts and spending, so it is
correlations and covariances that matter. That is because the social policy objective (for a credibly solvent state) is
typically taken to be tax smoothing, on the grounds that ex ante uncertainty about future taxes (and so ex post
volatility in actual taxes) will impede economic actors’ planning and, thus, social welfare, other things being equal.
Analytically, this would suggest various types of state-contingent debt, including GDP-linked bonds (as proposed
by Robert Shiller (e.g. Shiller, 2018)). Absent that, and given that unconditional forecasts of the incidence of
different types of shock are highly uncertain, the robust conclusion is often taken to be a debt structure that mixes
nominal and inflation-indexed bonds issued at a wide range of maturities (see, for example, Barro (1997) and
Chrystal, Haldane and Proudman (1999)).
11
By contrast, the US Federal Reserve did buy inflation-indexed bonds in its QE operations. The effect, ex post, has
been to spare the US the cost of compensating holders for the recent much-higher-than-expected inflation out-turns
(assuming the Fed holds the indexed bonds until maturity), but with elected politicians left with blunted incentives
to press the Fed to stick to a policy of low inflation (in particular, low domestically generated inflation).
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13
bank that can control domestically generated inflation (see Section 7.7).
12
The QE-induced risk
exposure that matters, therefore, concerns only the state’s consolidated nominal debt.
When does the risk exposure matter?
Whether the risk exposure matters, however, turns on more than probabilities, as a risk could
crystallise but be immaterial in its effects. Here things are a bit more subtle. Qualitatively, the
exposure does not greatly matter ex ante if the plausible possible paths for Bank Rate all average
around the plausible range for yields on medium-to-longer-term gilts, or ex post if Bank Rate is
not on average materially higher than the yields at which gilts were issued before being bought
by the Bank. As explained above, if those conditions are met then temporary divergences of
Bank Rate away from its expected path are not going to make much difference to the state’s
funding costs relative to the counterfactual of government financing itself in the market
(provided, as already stated, that fiscal credibility is solid).
In the ordinary course of things (assuming fiscal credibility), long-term bond yields would
reflect the expected path of the short rate, plus a so-called term premium to compensate investors
for locking up their funds (and assuming market-risk exposure if they might sell before
maturity).
13
When the expected path of policy rates is low (and the supply of long-maturity gilts
does not stretch demand), that term premium might be compressed because more asset managers
will try to enhance the returns on their investment portfolio by earning the illiquidity premium
(one of many manifestations of the proverbial search for yield).
That means that one reasonable indicator of the materiality of the risk exposure, ex ante, is
whether or not the long-term forward rate of interest (see annex) is roughly – in a plausible range
for – what people think will be the steady-state nominal rate of interest (roughly, Bank Rate).
Figure 7.4 shows the evolution over time of the 10-, 20- and 30-year forward rates for the 12-
month nominal rate of interest. It shows that in 2009 and 2010 when QE began, the long-run
forward rate was still around 5%, which is broadly consistent with inflation averaging 2% and
the real return on (roughly) risk-free assets averaging 2–3% over the long run. As such, the risk
12
The effect on the cost of servicing indexed bonds is permanent, because payments are indexed to changes in the
price level. That aside, the analysis differs where headline inflation rises due to an adverse shock to the terms of
trade (import prices rising relative to export prices), such as a sharp rise in world energy prices for countries that
import all or most of their energy. In those circumstances, one would not expect the monetary policy of a credible
central bank to have to become tight so as to restrain aggregate demand, and so the double whammy of higher
floating-rate interest payments and higher inflation-indexed payments is avoided. There is a double whammy,
however, if the cost shock (pushing up the price level) feeds through to expectations of future inflation, but that
should incentivise politicians to maintain a central bank resolutely focused, at all times, on maintaining anchored
medium-to-long-term inflation expectations. Talk a few years ago, in various industrialised countries, of running
the economy ‘hot’ might have obscured that vital incentive and interest.
13
Where fiscal credibility is absent or impaired, a further risk premium will be charged for the possibility either of
legal default or, for a country with its own currency, of government overriding central bank independence so as to
monetise its debts. That is mainly ignored here, but is touched upon in Section 7.8 (on quantitative tightening).
The Institute for Fiscal Studies, October 2022
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
14
Quantitative easing, monetary policy implementation and the public finances
exposure initially opened up by QE was not obviously material on this count, since borrowing at
a fixed long-term rate could be expected to be around the average of Bank Rate over the life of a
long-term bond.
14
Figure 7.4. Nominal 10-, 20- and 30-year forward rates, January 2005 to present
0
1
2
3
4
5
6
Per cent
10-year 20-year 30-year
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Note: Data run to 6 October 2022. Shaded areas indicate periods when the Bank of England was
undertaking quantitative easing and purchasing gilts via the Asset Purchase Facility. Data for 30-year
forward rates unavailable prior to 2016.
Source: Bank of England.
By mid-to-late 2019 – notably, before the 2020 COVID-19 pandemic began – long forward rates
were unusually low: the 20-year forward rate was between 1% and 2%, and the 30-year between
0% and 1%. Subject to one caveat, this implies that, ex ante, it would have been much cheaper to
fund the government by issuing long-term bonds to the market, thereby locking in the unusually
low long forward rates, than by borrowing at a floating rate from the Bank of England. That is
because Bank Rate would have been expected to be higher over the life of the bond than the long
forward rate. The caveat is that that inference would not hold for anyone who, at the time, had an
extraordinarily pessimistic view of the outlook for growth (and, therefore, the return on capital),
14
This reflects what is known as the Fisher equation (after Irving Fisher) that the nominal interest rate is equal to the
sum of the real interest rate plus (expected) inflation. The real interest rate is itself the sum of the risk-free real rate
plus various risk premia.
The Institute for Fiscal Studies, October 2022
IFS Green Budget 2022
15
and/or thought inflation would systematically undershoot the prevailing 2% target. There is no
evidence (we know of) that the authorities held either view, let alone both.
15
Figure 7.5. Nominal 10-, 20- and 30-year forward rates, 1 September 2022 to present
6
Per cent
5
4
3
2
1
0
10-year 20-year 30-year
MPC
decision
Fiscal
event
BoE MMLR
operations
announced
1 Sep 2022
3 Sep 2022
5 Sep 2022
7 Sep 2022
9 Sep 2022
11 Sep 2022
13 Sep 2022
15 Sep 2022
17 Sep 2022
19 Sep 2022
21 Sep 2022
23 Sep 2022
25 Sep 2022
27 Sep 2022
29 Sep 2022
1 Oct 2022
3 Oct 2022
5 Oct 2022
Note: Data run to 6 October 2022. Vertical lines indicate the MPC’s 21 September announcement, the
Chancellor’s 23 September fiscal event, and the start, on 28 September, of the Bank of England’s market-
maker-of-last-resort (MMLR) temporary gilt purchases.
Source: Bank of England.
There is also another contrast between the 2009–10 and 2020–21 episodes of QE. During the
former, in the aftermath of the financial crisis, there was slack in the economy, and thus no
meaningful prospect of domestically generated inflation requiring a period of tight monetary
policy. In consequence, the Monetary Policy Committee (MPC) was in a position to
accommodate various cost shocks that hit the UK during 2010–11. In the later period, by
contrast, it was harder to be so confident about domestically generated inflation pressures
remaining muted given persistent additions to monetary stimulus and, following COVID, a large
number of people withdrawing from the workforce (reducing the economy’s productive
capacity) – even before Russia’s war on Ukraine and the various resulting cost shocks. As it
15
Recently, the Bank of England has estimated that the equilibrium world real rate of interest is around zero (Bailey,
2022; Cesa-Bianchi, Harrison and Sajedi, 2022). If that is correct, with an inflation target of 2%, a long nominal
forward rate significantly below 2% points towards the cheapest expected funding coming via long-term fixed-rate
bonds, other things being equal. Research papers estimating a low R* include Rachel and Summers (2019).
The Institute for Fiscal Studies, October 2022
16
Quantitative easing, monetary policy implementation and the public finances
turned out, that risk seems to have crystallised, implying a period of tight monetary policy
during which Bank Rate will be above its expected long-run average. In other words, the public-
finance risk exposure created by floating-rate funding through 2020 and 2021 was exacerbated
by a non-negligible chance of an inflationary shock. The point is not that this should certainly
have been the expected outcome, but that it was a meaningful possibility – the risks to inflation
were regarded by some as plainly to the upside – raising the stakes of adding to QE.
Summing up, it is reasonable to conclude that by the autumn of 2019 it was clear there was
meaningful risk to the public finances from the combination of QE and paying interest on banks’
reserves.
7.3 Quantifying the opportunity costs and
risk exposure
Materiality in the probability of a risk crystallising and materiality in the costs of its crystallising
are obviously not the same thing. This section aims to put some numbers around the opportunity
costs and continuing risk exposure by looking at, in turn, the what-if of QE having stopped
before 2020, the sensitivity of funding costs to the path of Bank Rate, and the savings available
if interest was no longer paid on banks’ reserves.
Opportunity costs from funding via QE over 2020–21
An obvious place to begin, given the previous subsection, is to put some numbers on the savings
that might have been secured had the Bank not added to its QE after 2019, when it became clear
long-run forward rates of interest were unusually low. This involves assuming, counterfactually,
that throughout 2020 and 2021 the government borrowed in fixed-income markets (without any
fixed-to-floating debt swap) to fund the fiscal assistance provided to the country during the
pandemic, and that the Bank chose not to buy-and-hold more gilts.
The Bank of England bought £440 billion of gilts during that period.
16
To simplify things, one
plausible benchmark is to assume that, instead of QE, the government funded in the market at
the average yield over that period at the average duration of the conventional part of debt
portfolio (ignoring QE), which was approximately 12 years.
17
Assuming no effect on borrowing
16
Purchases of fixed-rate corporate bonds are ignored here because BEAPFF’s holdings are only around £20 billion
(a large number in normal circumstances but small in the current context).
17
This is the average modified duration (see annex) on the government’s (net) outstanding conventional gilts over
2020 and 2021. The average maturity of the government’s (net) outstanding conventional gilts over the same
period was around 14 years. Source: Debt Management Office Quarterly Bulletins (various).
The Institute for Fiscal Studies, October 2022
IFS Green Budget 2022
17
costs (see below), the interest rate incurred would have been approximately 0.7%.
18
In fact, a
respectable case could have been made for the government lengthening the duration of issuance
during this period to take advantage of the unusually low long-maturity forward rates, but that is
ignored here.
19
In the short run, funding via gilt issuance would have been more expensive than funding via QE
at Bank Rate, which averaged 0.17% over the period from 1 January 2020 to 31 December 2021.
But things were set to turn round once Bank Rate was returning back to something like neutral.
Taking the Bank’s recent estimate of the steady-state equilibrium nominal rate of interest of 2%
(and assuming no change in the outstanding amount of QE),
20
the annual savings would in
steady state have been roughly 1.3% (on the £440 billion of gilts), or £6 billion per year.
21
If,
instead, the equilibrium nominal rate were, say, 3% (roughly the 20-year nominal forward rate in
late August 2022, so before the recent fiscal-event shock), the steady-state savings would have
been nearly double: roughly 2.3%, or £10 billion per year. Using 2021–22 numbers for national
income, those steady-state savings would be around 0.2–0.4% of GDP per year, or 0.5–1.0% of
total government spending. If instead the equilibrium were 4.4% (the 20-year nominal forward
rate at the time of writing, 6 October – see Figure 7.5), the steady-state savings would rise to
3.7%, £16 billion per year, equivalent to 0.7% and 1.5% of 2021–22 GDP and total government
spending, respectively.
Those numbers assumed that if HMG had funded itself in the markets during 2020 and 2021,
that would not have affected yields. But long-maturity nominal forward rates were so low then
that the supply effect on yields would have had to have been in the order of 1–2 percentage
points for the implied steady-state saving to be wiped out. At the least, it can be argued that,
monetary policy considerations aside (see Assessment subsection below), government could
usefully have tested the waters rather than relying on Bank purchases.
22
18
This is the average (implied) yield on a 12-year zero coupon bond over 2020 and 2021, where 12 years is the
average duration of the nominal gilt portfolio over that period. The equivalent figure for a 14-year zero coupon
bond over the same period (14 years being the average maturity) is 0.8%.
19
A similar point was made in the 2020 IFS Green Budget (Emmerson, Miles and Stockton, 2020).
20
Bailey (2022) and Cesa-Bianchi, Harrison and Sajedi (2022) estimate the equilibrium world real interest rate at
0%, so a local inflation target of 2% implies an equilibrium nominal rate of 2%.
21
That calculation is for the longer-run annual savings from locking in very low long-maturity yields during 2020
and 2021. Of course, the shorter-run annual savings would have been even greater, being the difference between
paying approximately 0.7% on £440 billion of borrowing and paying a Bank Rate expected by markets (on 6
October) to average 5.6% over 2023–24 and 2024–25. The counterfactual below (not remunerating reserves) is
similar, but moves to paying zero on almost the totality of reserves (rather than just £440 billion).
22
Once monetary policy considerations are admitted, either the MPC would have had to have a change of heart about
QE or HMT exercised its right to veto further QE (unless, say, the reserves regime were reformed), putting
perceptions of independence in jeopardy. But that does not invalidate the utility of the thought experiment.
The Institute for Fiscal Studies, October 2022
18
Quantitative easing, monetary policy implementation and the public finances
Forward-looking risk analysis: the Office for Budget Responsibility’s
reports
That was backward-looking: assuming different policy choices on QE had been made over
recent years. Taking recent policy towards QE and reserves as given, the Office for Budget
Responsibility (OBR) has published two reports containing forward-looking analyses of the risk
to the public finances from the UK state’s de facto fixed-to-floating debt swap.
23
They approach
this by observing that the Bank’s operations have considerably shortened the average duration of
the debt stock. They calculate the reduction in the mean duration; and also, given that the mean
is lengthened by a few very-long-maturity bonds, in the median duration, which serves, OBR
points out, as ‘a direct measure of the time it takes for half of the full effect of a rise in rates to
feed through to interest payments’. In March 2021, the OBR reported that whereas the median
maturity of the government’s total gilt liabilities excluding the Bank’s APF was around 11 years,
it fell to 4 years if the APF was included. This meant that (as of March 2021) 59% of the
government’s debt liabilities would respond to changes in interest rates over the (five-year)
forecast period, compared with 44% in early 2009 (prior to QE). Relatedly, a 1 percentage point
increase in short rates was estimated to increase debt interest spending in the final year of the
forecast by three times as much as in December 2012: some 0.45% of national income
(equivalent to more than £11 billion in today’s terms), versus 0.16%.
24
The OBR has also explored the effect on debt-servicing costs of scenarios where the long-run
equilibrium real rate of interest (known as R*) rises with and without an equivalent increase in
the underlying rate of economic growth. Inflation is assumed to be at target, because the Bank is
assumed to anticipate the shocks. Obviously, the debt-to-GDP ratio rises when the equilibrium
real interest rate rises without a corresponding increase in growth. In its July 2022 analysis, the
OBR found that a permanent 1 percentage point increase in gilt yields without any change in
economic growth would, over a 50-year horizon, increase the ratio of debt to GDP by around 60
percentage points (from around 265% to around 325% of GDP).
25
These are important, useful thought experiments, but they do not exhaust the range of scenarios
where a reduction in the effective duration of the state’s consolidated debt proves costly. In part,
this is because the reduction in the debt stock’s median duration is not an adequate summary
statistic for the changes brought about by QE to the state’s debt structure. In principle, a
borrower could have a median debt duration of three years without having any debt that repriced
23
See box 4.1 of Office for Budget Responsibility (2021a) and paragraph 4.59 of Office for Budget Responsibility
(2022b).
24
See box 4.1 and supplementary expenditure table 3.21 of Office for Budget Responsibility (2021a) and box 3.3 of
Office for Budget Responsibility (2020).
25
See chart 4.17 and paragraph 4.59 of Office for Budget Responsibility (2022b).
The Institute for Fiscal Studies, October 2022
IFS Green Budget 2022
19
every month, and so without being sensitive to sharp but temporary shifts in the monetary policy
rate.
Figure 7.6. Overnight Index Swaps forward curve (short end)
6
Per cent
5
4
3
2
1
0
6 October
9 September
2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58
Maturity (months)
Source: Bank of England.
Figure 7.7. Overnight Index Swaps forward curve
6
5
9 September
6 October
Per cent
4
3
2
1
0
0.5
1.5
2.5
3.5
4.5
5.5
6.5
7.5
8.5
9.5
10.5
11.5
12.5
13.5
14.5
15.5
16.5
17.5
18.5
19.5
20.5
21.5
22.5
23.5
24.5
Maturity (years)
Source: Bank of England.
The Institute for Fiscal Studies, October 2022
20
Quantitative easing, monetary policy implementation and the public finances
In terms of illustrating the state’s risk exposure via scenario analysis, the point is that a
permanent shift in the long-run equilibrium real rate of interest without higher growth does not
exhaust the set of unpleasant scenarios. Another important scenario, as suggested in the previous
section, was, hypothetically, of a temporary sharp increase in Bank Rate in order to bring
domestically generated inflation back under control or to re-anchor medium-term inflation
expectations. Given the British state’s floating-rate debt, a temporary monetary policy shock of
that kind would, while it lasted, increase debt-servicing costs while temporarily pushing GDP
below the path that would have been sustainable in the absence of the inflationary shock. A
variant of that shock has, of course, occurred – initially as underlying inflationary pressures
became apparent to financial-market participants, and intensifying after the fiscal event of 23
September. Taking the current (6 October) market-implied path for Bank Rate (shown in Figures
7.6 and 7.7) and the Bank’s announced plans for unwinding QE,
26
the cost of servicing the QE-
related debt (at Bank Rate) would be £90 billion between now (October 2022) and March 2025
(£42 billion and £33 billion in each of the next two financial years).
27,28
We return to this below.
These figures are sensitive to the future path of Bank Rate. To underline the sensitivities: given
the Bank’s announced plans for selling off part of its £800 billion plus QE gilt portfolio, every 1
basis point increase (decrease) in Bank Rate would increase (decrease) cumulative debt-
servicing costs over the coming two financial years by around £130 million. Put more
dramatically, that means an increase of more than £13 billion over 2023–24 and 2024–25 if the
path of Bank Rate were 1 percentage point higher than currently expected over that period; £6.5
billion (the average over the two years) is around 0.2% of GDP.
The broad point here is the need to find a way of analysing risks without the Bank assuming the
state’s fiscal position is definitely sound, and likewise without the OBR assuming the Bank’s
credibility suffers no hits. Navigating this is obviously not easy, but the prevalence of floating-
rate debt increases its importance.
26
Again, the reserves counterpart to the TFS assets are ignored here because both the reserves and the TFS loans are
priced to Bank Rate.
27
On 9 September, two weeks before the fiscal event, that number would have been £67 billion, comprising
£31 billion and £22 billion for, respectively, the next two financial years. Some City and think-tank economists
forecast a lower path for Bank Rate (under the Citi forecasts used elsewhere in this IFS Green Budget, for instance,
the figure would be £65 billion, with £32 billion and £18 billion in the next two financial years), but it is standard
to use the market curve, since that reflects a pooling of diverse views.
28
If, instead of assuming that the stock of reserves falls in line with the Bank’s published plans for unwinding QE,
we assume that the stock of reserves remains as it is now, this figure would rise to £111 billion (with £49 billion
and £46 billion in the next two financial years). If we assume that maturing bonds held in the APF are not
reinvested, but that the Bank does not undertake any active asset sales, it would be £105 billion (£47 billion and
£42 billion).
The Institute for Fiscal Studies, October 2022
IFS Green Budget 2022
21
Counterfactual-regime analysis: not remunerating (most) reserves
An alternative forward-looking approach is to calculate what might be saved if the Bank’s
regime for implementing monetary policy were configured differently. Two London-based think
tanks – the National Institute of Economic and Social Research (NIESR) and the New Economic
Foundation (NEF) – have done this, with somewhat different counterfactuals. They each
quantify fiscal savings from the state adopting their respectively favoured reform proposals, and
thus provide illustrations of some crystallisations of the state’s risk exposure by estimating
losses in the absence of those reforms. In other respects the two studies differ. The NIESR
proposal is discussed below (Section 7.8). Here we discuss the simplest counterfactual, which is
to assume that interest is not paid on banks’ reserves (and for the moment abstract from
behavioural effects).
29
Of course, so long as Bank Rate was held at 0.1%, the quantitative effect would have been
small: on average under £2 billion per year (less than 0.1% of GDP) between 2009 when QE
began and 2 August 2018 when Bank Rate was raised to 0.75%.
30
It remained low – slightly
over £2 billion, again just under 0.1% of GDP per annum – from then until May 2022 when
Bank Rate was raised to 1%. The numbers were, however, set to become meaningful as Bank
Rate returned to something like normal.
That point was raised by various commentators and former policymakers in evidence to the
House of Lords Economic Affairs Committee during 2021. It gained wider publicity only when,
in mid 2022, the think tank New Economics Foundation (NEF) proposed dropping interest on
reserves (Van Lerven and Caddick, 2022). Taking account of Bank of England statements about
the prospective unwinding of QE and without taking into account any fiscal costs elsewhere
(say, lower corporation tax revenues) due to the de facto tax on banking intermediation (Section
7.6), they calculated a gross saving of roughly £57 billion over the three years to March 2025:
roughly £19 billion per annum, or around 0.8% of national income and 1.8% of total government
spending (for 2021–22).
31
Without implying any endorsement, the arithmetic was correct: there
29
As connoisseurs will recognise, strictly it is the total stock of reserves that matters here, not merely the part
corresponding to the QE gilt purchases (£838 billion as at 5 October 2022). The total stock of reserves as at 5
October was around £947 billion. Not using this bigger number (generating still bigger savings) is equivalent to
assuming that roughly £100 billion of reserves go into the corridor regime for ‘marginal’ reserves described in
Section 7.4. There is no suggestion that, if it were to adopt tiered-reserves, the Bank should leave exactly
£100 billion in the corridor. The calculation in the main text serves merely to illustrate the (large) sums involved.
30
Source: IFS calculations using ONS series FZIQ (BoE: Asset Purchase Facility: total asset purchases) and
historical Bank Rate.
31
In a variant, NEF assume £337 billion – approximately 40% of the stock of reserves – continued to be remunerated
at the policy rate, in which case the estimated saving is around £22 billion cumulatively over three years.
The Institute for Fiscal Studies, October 2022
22
Quantitative easing, monetary policy implementation and the public finances
would be a very large gross saving from borrowing at a rate of 0% rather than at the path of
Bank Rate, unless it were negative for a long period.
Given that, even before the recent fiscal event, the (market-implied) expected path of Bank Rate
was steeper than when the NEF published in mid June, the expected savings today would be
greater. After the fiscal event, the NEF proposal would now save (almost all of) the £90 billion
of interest payments on reserves implied by the market curve for the coming two-and-a-half
years (see above).
32
Of course, there are questions about how a measure along the lines proposed by NEF would
affect aggregate welfare given the possible effects on banking, but that (discussed in Section 7.6)
is separable from the narrow funding arithmetic.
Assessment of the significance of the public-finance risk exposure
The purpose of this section, and the previous one, has been to assess whether the risk to the
public finances from de facto floating-rate funding is sufficiently significant to make debate
about regime reform worthwhile. That depends on the probability of the risk exposure
crystallising in an adverse way, and also on the scale of the hit to the public finances if it does
crystallise. Both legs of the question can now be answered in the affirmative: the exposure does
matter.
While, as reflected in the OBR’s scenario analysis, permanent adverse shocks to the
government’s financing costs matter most, temporary sharp adverse shocks can be meaningful
too. The various benchmarks and counterfactuals explored in this section all generate large
numbers. Funding in the market rather than via QE during 2020–21 might eventually have saved
around £6 billion per year for a few decades (even before September 2022’s fiscal-event shock).
Funding via QE but not paying interest on any reserves would, if feasible, have saved around
£2 billion per year to date, but the implied saving is about to become much larger: potentially
more than £30 billion in each of the next two financial years. The underlying point of the OBR
risk analysis was that Bank Rate might rise more than expected: that risk has crystallised through
a combination of external and internal shocks to headline inflation and to inflationary pressures.
To put those numbers in context, in the decade or so since the 2007–09 financial crisis, debt-
servicing costs have averaged 1.9% of GDP, equivalent to £45 billion in 2021–22 terms.
Looking backwards, the potentially available (but forgone) savings from not remunerating
32
As per footnote 28, this figure would be greater if the stock of reserves remains as it is now, or if the Bank of
England does not undertake any active asset sales.
The Institute for Fiscal Studies, October 2022
IFS Green Budget 2022
23
reserves since QE began would have been small: less than 0.1% of GDP, or less than 5% of
average debt-servicing costs since the financial crisis. Even with remunerated reserves, funding
via gilt issuance would have in fact been more expensive than funding via QE at Bank Rate over
2020 and 2021. But looking ahead, the potential savings under both counterfactuals are much
bigger because Bank Rate is expected to rise.
Depending on what one assumes about the equilibrium nominal rate of interest, the plausible
forgone annual savings in steady state, relative to QE-with-remunerated-reserves, from locking
in £440 billion of fixed-rate borrowing in the market during 2020 and 2021 range between 0.2%
and 0.7% of GDP per year. That is between 13% and 36% of average debt-servicing costs, or
between 1.6% and 4.5% of annual spending on defence, the health service and education
33
combined.
The potentially available short-run savings if (the bulk of) reserves were no longer remunerated
are greater still: perhaps between 1.2% and 1.6% of GDP over the coming two financial years
(based, again, on 6 October market expectations). That is equivalent to 63–84% of average debt-
servicing costs (obviously big); or 7.6–10.5% of annual spending on defence, health and
education. This would reduce prospective annual debt-servicing costs (as per the forecast in
Chapter 3 of this IFS Green Budget) from around 3.9% to around 2.3% of GDP in 2023–24, and
from around 2.7% to 1.5% of GDP in 2024–25.
In reality, then, these numbers are big enough to affect political choices on spending and
taxation. That might work through the government’s fiscal objectives (or ‘rules’). While the new
government’s fiscal framework is not yet wholly clear, the previous framework included a
provision that non-investment spending (including interest on debt) minus taxes and other
current receipts should be in balance (or surplus) by year three, so that central government is
borrowing only for investment by then.
34
A sharp hit to debt-servicing costs for a number of
years could make that objective (or anything like it) harder to achieve without unpalatable
choices.
Summing up, one question posed by this analysis is whether the QE undertaken during 2020 and
2021 was the only reasonable course for the Bank. Some analysts (including this author) have
argued that the interventions in the gilt market in the spring of 2020 would better have been cast
as emergency and so temporary MMLR operations to bring order to a destabilised market and
33
In 2021–22, total government spending amounted to £1,058 billion or 44.5% of GDP. Combined spending on
health, defence and education amounted to £366 billion, or 15.4% of GDP. Between 2008–09 and 2021–22,
spending on these items averaged 14.2% of GDP; between 1997–98 and 2007–08, 12.3%. Source: IFS TaxLab.
34
Under the fiscal regime prevailing until recently, the other rule was: for public sector net debt to be falling as a
percentage of GDP by the third year of the forecast. (See, for example, paragraph 4.3 of Office for Budget
Responsibility (2022a).) The new government has reiterated this but for the ‘medium term’ (perhaps implying the
horizon might be extended to, say, five years).
The Institute for Fiscal Studies, October 2022
24
Quantitative easing, monetary policy implementation and the public finances
provide emergency funding for government. Had that course been taken, the purchases would
have been unwound later in the year, once markets had stabilised, leaving HMG able to fund
itself in the market. The broader economic rescue would have been entirely fiscal not monetary,
with the Bank playing its part by continuing to keep its policy rate low. In other words, if one
thinks the 2020–21 QE was unnecessary to achieve the inflation target, there was a very large
opportunity cost to the public finances that cannot easily be explained away.
Those are bygones. QE having in fact continued up to and into 2022,
35
the current question is
whether anything can be done now to reduce the public finances’ continuing risk exposure.
Since the only way to have wholly eliminated the exposure was (and is) not to pay interest on
reserves, it matters why central banks moved to paying interest on reserves, whether those
reasons apply during prolonged QE, and what the effects might be of suspending interest on
reserves. The next sections address those questions.
7.4 Central banking reserves policy
Central bank money takes two forms: paper notes, and banks’ deposit balances with the central
bank. Historically, interest was paid on neither. It cannot feasibly be paid on physical notes.
36
For nearly two decades, the main central banks have paid interest on banks’ balances (reserves).
Two questions arise: what are banks’ reserves, and why did central banks shift to paying interest
on them?
Since the 18
th
century, the monetary systems of the advanced economies (and later others) have
had a stable structure. Households, businesses, charities and others all bank with small or large
banks. Small banks have often banked with large banks. Large banks bank with the central bank.
When the central bank buys government bonds from, say, a pension fund, the pension fund’s
deposit balance with its bank increases, and if that bank banks directly with the central bank,
then its balance with the central bank increases. Subsequently, if the pension fund buys assets
from, say, an insurance company, and that insurance company banks with a different bank, the
reserves balance at the central bank is transferred from the pension fund’s bank to the insurance
company’s bank. While the reserves balance of each bank changes (one goes down, the other
up), the aggregate quantity of reserves (central bank money) does not change.
The last point is very important. While individual banks can seek to shed or accumulate reserves,
by buying or selling assets, the banking system as a whole cannot affect the quantity of
35
The reinvestment of maturing proceeds ceased in March 2022. Incremental net purchases ceased in December
2021.
36
Some academics, including Willem Buiter and Charles Goodhart, have articulated schemes for doing so.
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aggregate reserves. Only transactions with the central bank can affect the aggregate quantity of
reserves (plus pound notes).
37
Why pay interest on reserves?
Historically, central banks did not pay interest on reserves, the Bank of England being no
exception. This meant that individual banks wanted to minimise their reserves balances, so that
they could instead hold an asset that provided them with a return. When the central bank injected
more money into the economy, banks’ (and others’) demand for government bonds would rise,
pushing up the price of those bonds and so reducing the yield on them. In other words, so long as
demand for reserves had not changed, injecting more money led to lower market interest rates,
i.e. easier monetary policy.
Some central banks set minimum reserve requirements, often determined by the size or growth
in a bank’s own monetary liabilities (most obviously, current-account balances held by
households and firms). From the early 1980s, the Bank of England did not set reserve
requirements. Instead, the main clearing banks chose what (non-zero) balance they aimed to hold
each day at the Bank. Those target balances were very low. This meant that, in order to avoid
banks continually going into overdraft, the Bank had to ensure each day that its aggregate supply
of reserves met demand, but no more. One result was hyperactivity in the Bank’s monetary
operations (open-market operations), and another was persistent volatility in the overnight rate
of interest in the money markets. Since the former was avoidable and the latter undesirable, the
Bank implemented a major overhaul of its money market operational framework in 2005–06,
before the global financial crisis (Tucker, 2004; Clews, 2005).
The new system – known as ‘voluntary reserves averaging’ – allowed almost any bank to bank
with the Bank, and had each bank set itself a target level of reserves to hold on average over the
month between one Monetary Policy Committee meeting and the next (the ‘monetary
maintenance period’). Since the Bank wanted the reserves banks each to hold a healthy balance
that minimised the prospect of overdrafts, it offered to pay the MPC’s policy rate (Bank Rate) on
balances close to each bank’s target, with standing deposit and lending facilities paying and
charging rates of interest close to Bank Rate.
38
Since this entailed remunerating reserves, the
37
It is, therefore, a mistake to suggest that central banks paying interest is as natural as commercial banks doing so;
for example, the BBC’s More or Less radio programme saying that ‘the Bank of England was paying a little bit of
interest on [reserves], because, well, that’s how bank accounts work, even when they’re bank accounts at the Bank
of England.’ (26 June 2022, https://www.bbc.co.uk/programmes/m0018gql). It is a mistake because whereas
numerous private banks compete to attract customer deposits, there is only one central bank and the reserve banks
(in aggregate) have no choice over whether to hold the reserves it creates. They can seek only to pass the parcel.
38
Each bank then chose a target level for average reserves taking account of the need to cope with payments shocks
and the expected policy rate.
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Quantitative easing, monetary policy implementation and the public finances
Treasury was consulted on whether it objected to the proposed reforms, and did not do so (see
Section 7.7 on how this fits with Bank of England independence).
In other words, the Bank of England’s decision to pay interest on reserves was taken in the
context of reforms to its operating system in normal circumstances, and was nothing to do with
the introduction of QE. By contrast, the US Federal Reserve (the Fed) did move to paying
interest on reserves in the context of its QE purchases after the 2008–09 financial system
collapse. In both cases (and elsewhere), since QE was not expected to persist for many years and
because long-maturity forward rates remained quite high, the possibility of the serious public
finance implications explored here was remote.
Setting interest rates under QE
The Fed moved to remunerating reserves because it faced a problem of how to establish its
policy rate of interest in the market once it was conducting QE on a significant scale. The
challenge arises because QE injects a quantity of reserves into the market far beyond the banking
system’s aggregate demand for reserves. In consequence, absent other measures, the market rate
of interest would fall to zero (assuming banks and others do not set themselves up for negative
interest rates).
But some central banks did not want nominal interest rates to fall all the way to zero because
they were concerned that this would damage the viability or even the solvency of some banking
institutions. Since the QE was being undertaken to help the economy recover after a banking
collapse, that would have been perverse because it would have exacerbated problems with the
supply of credit. In consequence, in many jurisdictions monetary policymakers wanted to put a
non-zero floor on money market rates of interest. In the UK, the MPC was explicit about this.
Later, when the economy recovered and inflationary risks appeared, central banks responded by
raising the floor on market interest rates. That is to say, they wanted to raise the path of the
policy rate of interest even while there remained an outstanding quantity of reserves hugely
exceeding demand.
Central banks were able to put a floor under market rates by remunerating reserves at (or around)
their chosen interest rate. This regime, known as a ‘floor system’, meant they could raise their
policy rate without reducing the stock of outstanding QE (and, hence, their supply of reserves).
When the supply of reserves exceeds demand, the central bank controls the rate of interest in the
overnight money markets by being the marginal taker of funds. The central bank is the marginal
taker of funds if the rate it pays on deposits exceeds the rate that would clear the market
spontaneously.
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One big policy question, therefore, is whether a central bank has to remunerate the whole stock
of reserves at the policy rate in order to implement its monetary policy. The answer is, no.
This breaks down into two issues, corresponding to the two instruments of monetary policy: QE,
and setting a policy rate. First, do the details of the reserves regime affect the way QE itself is
transmitted into the economy in ways that help a central bank achieve its inflation target? And,
second, does a central bank conducting QE have to remunerate all reserves at (or close to) its
policy rate in order to be able to achieve its chosen policy rate in the money markets?
The reserves regime and the transmission of QE
On the first, there are two (perhaps three) broad accounts of how QE stimulates spending (if in
fact it does when financial markets are stable): by compressing term premia through a portfolio-
rebalancing channel; and, quite differently, by reinforcing any signal-cum-promise, via ‘forward
guidance’, that the policy rate will remain low for a long time.
39
Trivially, the design of the
reserves regime does not affect QE’s effects on term premia, since that depends on the central
bank withdrawing longer-term bonds from the market.
40
By contrast, the reserves regime might conceivably have a bearing on the signalling account of
QE.
41
That is because reneging on a promise to keep rates low (at zero, say) will be more costly
to the state if the entirety of reserves are remunerated at the policy rate. But a challenge to the
signalling theory is that it is unclear how it can explain central bank choices on the quantity of
QE. Once the stock of QE is large enough to be financially painful if sold off into a falling
market (rising yields), why would the central bank need to do more to underline the credibility
of its commitment to low policy rates?
Separately, if the economy suffers an inflationary shock of some kind – especially one to
domestically generated inflation – why would the economic costs of letting inflation and
inflation expectations rise above target not be weighed against the financial costs of departing
from ‘low for long’ commitments? The financial costs of breaking the promise are just what
come with faithfully sticking to the mandate of maintaining low and stable inflation. If, despite
that, full remuneration of reserves were to cause central banks to shy away from a pre-emptive
39
The third view – the bank-lending channel – cannot realistically be affected by reserves regimes that either fully
remunerate, or freeze a quantum of unremunerated reserves.
40
This mechanism nests those associated with rebalancing investor asset portfolios. The effects running through first-
round changes to broad money are not addressed here.
41
The signalling account itself comes in two variants. One bases the credibility enhancement on the exposure to
losses: the central bank / monetary authorities putting their money where their mouth is. The other holds, more
simply, that doing something is more compelling than the pure talk of forward guidance. The latter is not addressed
in the main text because its merits, if any, are not affected by whether reserves are remunerated or unremunerated.
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Quantitative easing, monetary policy implementation and the public finances
response to an inflationary shock, then full remuneration of reserves during periods of QE is not
a good thing.
For the purposes of this chapter, therefore, we conclude that however QE works to stimulate
aggregate demand, either its effectiveness does not depend on the design of the reserves regime
(the portfolio rebalancing / term premium view), or full remuneration might be
counterproductive taking account of the full range of plausible shocks (the signalling view).
Setting interest rates in the face of massive excess-reserves supply
The bigger question is whether central banks need to remunerate the whole stock of reserves in
order to steer overnight money market rates in line with their chosen policy rate. It is central to
this chapter that that is not, in fact, the only technically feasible option.
In order to deliver an overnight money market rate of interest in line with its policy rate, the
central bank needs to be ready to act as either the marginal taker of funds, the marginal provider
of funds, or both. When the quantity of reserves supplied systematically exceeds demand, it must
be the marginal taker of funds: a floor system (see above). When reserves supplied fall short of
demand, it must be the marginal supplier of funds: a ceiling system. The latter is how the Bank
of England implemented monetary policy before the Second World War: when the market rate
fell below its desired rate, the Bank would undersupply reserves via its open-market operations,
forcing the banking system to borrow at the discount window at the Bank’s preferred rate
(Tucker, 2004, pages 21–25 and annex 3).
Where there is neither a systematic oversupply of reserves nor a systematic undersupply, the
central bank must be the marginal actor on both sides of the market, taking and lending money at
a rate close to its policy rate. The wedge between its deposit rate and its lending rate implicitly
indicates its tolerance for money market rates to diverge from its policy rate. This is known as a
corridor system. The narrower the corridor, the more overnight inter-bank activity will be
conducted across the central bank’s balance sheet.
All operating systems for monetary policy framed in terms of the price of money (the policy
rate) rather than the quantity of money are explicitly or implicitly corridor systems. A floor
system, as employed in recent years, needs only one side of the corridor.
The key word in that description of monetary operating systems is ‘marginal’. The central bank
does not need to pay or charge its policy rate (or something close to it) on infra-marginal
reserves in order to establish its rate in the money markets. That being so, the operational-policy
question is how to separate infra-marginal reserves from marginal reserves.
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7.5 Reserve requirements with tiered rates
The issue that sets up is how to reduce the cost to the taxpayer of paying the policy rate on the
bulk of the reserves created by QE without losing control of overnight market rates. The
technical solution is to introduce a system of tiered interest rates on a bank’s reserves balance.
This section looks at how that would work for monetary policy, and the next at the likely
incidence of a possible de facto tax on banking from no longer remunerating the totality of
reserves held by banks at the Bank.
A tiered rate would involve setting a reserve requirement for the bulk of reserves (say, for
illustration, 95% of the current stock) earning a rate of interest below Bank Rate (possibly zero),
together with a ‘corridor system’ for the remaining reserves circulating in the market. Whenever
a bank’s reserves dipped below or were above its required level, the corridor system for steering
the market rate would bite.
For the system as a whole, if the total reserves supplied exceeded demand, the overnight market
rates would settle around the deposit-facility rate. If demand exceeded supply, it would settle at
the lending-facility rate. A policymaker would probably want a narrow corridor to reduce the
prospect of frictions in the inter-bank money markets causing the overnight rate to bounce
around between floor and ceiling. There need not be any routine open-market operations to steer
quantities.
The determination of each bank’s reserves requirement
Such a scheme has a number of design parameters. Some technical ones are briefly discussed in
Box 7.2, including adjusting the requirement for future central bank transactions (whether
unwinding QE, adding to it, or other transactions). Here the focus is on two big ones: how the
amount of reserves earning the sub-market rate (the reserve requirement) is determined for each
individual bank, and the rate of interest paid on those ‘required’ reserves. Those choices would
drive the extent of any saving for the public finances.
On the design of the reserves requirement, the choice is essentially between a wholly history-
based requirement or, alternatively, a requirement set in terms of some current or lagging
balance-sheet quantity (for example, as a percentage of on-demand deposits).
42
A feature of the
second approach is that it would affect banks’ behaviour, since whatever base the reserves
requirement was set off, banks would have incentives to minimise that base in order to minimise
the costs to them of holding unremunerated balances at the Bank (see Section 7.6). In other
42
The reserves requirement might well need to be set via regulation or some other legally binding instrument so that
individual banks did not seek to escape the requirement by simply giving up their reserves account. The mechanics
of that are not pursued here.
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Quantitative easing, monetary policy implementation and the public finances
words, a reserves requirement of that kind would be an instrument of monetary policy and not
just a means of addressing the public-finance risk exposure. For that reason, it is set aside here,
but a central bank would want to think through those issues.
Wholly history-based formulae do not have that effect, since banks cannot rewrite the past. One
possibility would be to determine each bank’s reserves requirement (in pounds) in terms of a
fraction of aggregate required reserves, with that fraction set equal to the fraction of aggregate
reserves the bank had actually held over a specified number of years before tiered remuneration
began. That history-based average could be calculated for a period starting from the date QE
began in 2009, or later (say, 2016 given the injection of reserves by QE that year, or 2020).
The requirement might need period-by-period adjustment for the central bank’s ongoing
operations that inject or withdraw reserves, but that is a detail of operational policy (Box 7.2).
More important, one lesson since QE commenced in 2009 is that special monetary operations
can sometimes last a lot longer than policymakers expect; the implicit assumption in 2009 was
that QE would be unwound as the economy recovered. If the new system lasted a very long time,
there might be some injustice if the relative size of banks changed materially over a number of
years; that might occur organically, through changes in business strategy, or through mergers
and new entrants, etc. For that reason, the new system would need to include a provision to the
effect that the central bank reserved the right to change the history-based reserves-requirement
rule. But it would be important to give no indication of how or when it might do so, since that
would reintroduce the strategic behaviour that a history-based requirement is intended to avoid.
Box 7.2. More technical matters for a tiered-reserves regime
Just as any policy should be underpinned by clear and analytically coherent principles, so any policy
must be capable of being operationalised; otherwise, it is just so much idle thinking. Operationalising a
system of tiered reserves remuneration would raise a host of technical questions for operational policy.
Four obvious and important ones are discussed here, in the spirit of testing whether implementing a
system of tiered reserves would hit insuperable obstacles.
Determining the amount of reserves that is marginal
For the purpose of establishing its policy rate in the money markets, a tiered system might seem to
require the central bank to know the amount of reserves needed in the monetary system over and above
required reserves. That is not so. Provided the corridor (see main text) is sufficiently narrow that
policymakers are indifferent to whether the market rate sits at the top or bottom of the corridor, it does
not need to form a view. If policymakers wish to operate with a wider corridor – say, because they
wish to enable a private market in overnight money – they can adjust the level of required reserves
(and/or the quantity of reserves supplied by open-market operations) from maintenance period to
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maintenance period until the overnight market rate settles somewhere around the middle of the
corridor.
Unwinding QE within a reserves-requirement regime
At the time of writing, the MPC is planning to unwind QE, through a combination of not reinvesting
the proceeds of maturing gilts and selling outstanding gilts (quantitative tightening, QT). Both
withdraw reserves from the system. For the possible tiered-remuneration regime aired in the main text,
there is a choice as to whether the drained reserves should come out of required reserves (earning zero)
or the residual (marginal) quantity of reserves through which the policy rate is set. The obvious route is
to reduce the aggregate stock of required reserves, with pari passu reductions for each individual
bank.
a
As gilts are sold, the structure of the state’s consolidated debt will change again, with fewer floating-
rate liabilities and more fixed-rate debt. There will, though, still have been an opportunity cost. As at
the time of writing (end-September), both 10- and 20-year gilt yields are around 4.1%, compared with
3.1% (10-year) and 3.5% (20-year) on 9 September (two weeks prior to the fiscal event), and 0.2% and
0.7% at the end of 2020. The Bank has said that, after consultation with the debt office, it aims to sell
£80 billion of gilts over the next 12 months. The opportunity cost accordingly ranges between
approximately £2.7 billion and £3.1 billion per annum (based on post-fiscal-event gilt yields).
b
That is
equivalent to the entire budget of the UK security services (the Single Intelligence Account,
£3.1 billion in 2021–22).
Treatment of unremunerated required reserves under the regulatory Liquidity
Coverage Ratio
Another technical question that might arise is how apparently semi-frozen required reserves might be
treated under the prudential Liquidity Coverage Ratio (LCR). An argument for reduction might be
advanced: if such reserves cannot be used then how can they possibly count as liquid assets for
prudential purposes, but if they can be used then how can they be regarded as frozen since banks
would seek to get rid of them to escape the lack of remuneration.
The first thing to say is that the required reserves are not frozen. Any balance with the central bank is
plainly an ultimate source of liquidity, and so should count towards meeting the LCR. Instead, it is a
matter of what price should attach to falling below the required level. As discussed in the main text,
the answer is the spread above the policy rate charged on the corridor system’s marginal lending
facility. Remaining zero-remunerated reserves could be used as collateral for such borrowing: if a
borrowing bank defaulted on its loan, the Bank would realise collateral held in the form of reserves by
cancelling its liability.
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Quantitative easing, monetary policy implementation and the public finances
Incentivising use of the marginal lending facility
Finally, there is an esoteric question about what rate should be charged if a bank’s reserves balance
goes below the required level but it chooses not to borrow from the corridor facility in order to get
back to target. There are two approaches. One would have the Bank effect a loan from that facility, i.e.
involuntary borrowing at the lending-facility rate. The other would be to charge a higher penalty rate
for such passive ‘overdrafts’ in order to incentivise use of the corridor facility. Determining which is
better depends partly on the times of day when the facilities and payments systems close and is beyond
the scope of this chapter.
a
As has become apparent over the past year or so, perhaps especially in the US, the word ‘tightening’ can be
misleading as it elides an important distinction between, on the one hand, whether policy is stimulating or restraining
aggregate demand (determined by the level of interest rates) and, on the other hand, whether policy settings are
reducing the degree of stimulus (a point about changes). Briefly, tightening policy does not mean it is tight.
b
Based on gilt yields two weeks prior to the fiscal event, the approximate opportunity cost would be £2.2 billion to
£2.3 billion.
The sub-market rate paid on required reserves
One other question of principle stands out: the rate paid on required reserves. The central bank
could choose.
Choosing a non-zero (but positive) rate below the policy rate would cut but not wholly eliminate
the public-finance risk exposure. Any such non-zero rate could be set as an absolute amount or
as a spread under Bank Rate. Other things being equal, the latter would leave the public finances
more exposed to rising debt-servicing costs if Bank Rate were to rise very sharply in the period
ahead.
Alternatively, the rate could be zero. Choosing zero would eliminate the public-finance risk
exposure on that quantity of government financing, as the cost to the consolidated state would be
zero. For a central bank, that might be thought the easiest choice to defend in terms of a
principle: money provides a service but not a financial return (but see Section 7.6). Without
specifically recommending zero, the rest of the chapter assumes that is the choice (unless the
context makes clear).
43
43
The possibility of paying a negative rate of interest on required reserves is ignored here as the Bank of England has
not articulated whether it would ever set a negative policy rate (paid and charged on marginal reserves). Were that
ever to happen, the spirit of the argument here might imply setting a still lower rate of remuneration for required
reserves. But that would need to be thought through as part of examining the wider effects of substantially negative
market interest rates, and is not addressed here.
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Existing tiered-remuneration reserves systems
Systems of tiered rates are not a novelty in themselves. When it moved to paying a negative
interest rate on marginal reserves, the European Central Bank continued to pay a higher rate on
the bulk of the stock of outstanding reserves (effectively subsidising the banks). The Bank of
Japan has operated a similar regime for essentially the same reasons: to avoid a hit to bank
profitability that could adversely affect the supply of loan finance.
44
The difference here is that the rate paid on the bulk of the stock of reserves would be lower than
the central bank’s policy rate. On the face of things, it would be like a tax rather than a subsidy.
This poses the vital question of where the incidence of the tax would fall, and how this would
bear on the country’s economic welfare and prospects.
7.6 A de facto tax on banking, or a transfer to
bankers? Efficient allocation of
resources, pass-through to customers
and implications for credit conditions
Any saving for the public finances from altering the Bank’s reserves regime is obviously lost
income for the banks. This raises the question of whether what the state gained directly, it would
lose indirectly. The issues are taken under three headings: the effect on allocative efficiency of
any tax on banking intermediation; whether the banks themselves would be harmed, jeopardising
stability; and implications, short of instability, for macro-financial conditions.
Public-finance efficiency
One point of departure is Milton Friedman’s dictum that, for an efficient allocation of resources,
money should earn the risk-free rate of interest minus any convenience yield from the payments
service it provides as a medium of exchange. From that vantage point, paying the full policy rate
is too much given money’s convenience yield, but moving to unremunerated reserves would
44
For a summary of such tiered-reserves systems, see Deutsche Bundesbank (2021, box on pages 64–66).
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Quantitative easing, monetary policy implementation and the public finances
impose a tax.
45
Moreover, by the lights of orthodox public-finance economics, it would be an
inefficient tax for a number of reasons.
46
It would distort behaviour, contributing to an
inefficient allocation of resources, because banks would seek to pass it on (non-neutrality; see
below). It would (arguably) tax an intermediate good, i.e. a good or service (banking
intermediation) that is an intermediate input to the production of final goods and services.
47
And
it would be highly variable, because the wedge between the return on unremunerated reserves
and the market rate would change (more or less) every time Bank Rate changed.
Of course, for good or ill, modern economies rarely employ non-distortionary taxes. And a
history-based requirement for unremunerated reserves could not be avoided, and so, at least over
the short-to-medium run, would not directly distort current choices on the provision of banking
(deposit and lending) services.
48
Further, arguably banking intermediation is not a pure
intermediate good, so the strictures against inefficient taxation of inputs to production might not
apply with their usual force.
Nevertheless, at a high level, there would be a tension in introducing a suboptimal tax to cure a
costly suboptimal debt structure. They would standardly be regarded as independent issues. As
such, if brought together, there is a choice between, on the one hand, imposing suboptimal taxes
today (to avoid higher borrowing brought about by a suboptimal debt structure) and, on the other
hand, accepting higher borrowing today (to avoid imposing inefficient taxes) and accepting the
prospect of having in the future to impose higher taxes (on incomes and consumption) and/or to
cut the provision of public services. Where the state concerned faces no risk of being credit
constrained in the future, efficiency considerations point towards choosing the latter course:
solving the debt-burden problem over time by taxing final goods.
45
See Friedman (1959, chapter 3). Remunerating reserves is not wholly faithful to the spirit of the Friedman doctrine
as cash is not remunerated; so remunerating banks’ reserves treats banks differently from members of the public.
Also, Friedman’s doctrine was framed in the context of narrow banking (where banks cover all demand-deposit
liabilities with reserves). Separately, not paying the policy rate on reserves is here described as a tax for the
following reasons. Absent compulsion, the quantity of unremunerated reserves that any individual bank would
choose to hold would reflect the fact that they are completely safe (default risk free and the ultimate source of
liquidity) and also provide a convenience yield (given a bank’s intraday and day-to-day need for immediate
liquidity to meet payment obligations). But if, whether de facto via QE or de jure via a reserves requirement, banks
have to hold more unremunerated reserves than any would freely choose, then they are effectively being taxed
(presumptively: see main text).
46
Pigouvian taxes designed to get banks/bankers to internalise the stability-threatening externalities generated by
leverage and liquidity mismatches are a separate matter.
47
Even where all taxes are distortionary, taxing pure intermediate goods is, in principle, inefficient as it distorts the
allocation of factors of production between intermediate and final goods. See Diamond and Mirrlees (1971 and
1976). This assumes, however, that other tools are available to government. In their absence, distorting
intermediate goods might be a second-best option.
48
Although, as noted earlier in the main text, the monetary authority might eventually, as the market share of banks
changed, need to recalibrate the unremunerated reserves regime.
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Where, however, a state might face a default-risk premium in the terms on which it can borrow,
the choice is not so straightforward. In those circumstances, public-finance orthodoxy currently
still says it would be more efficient to impose a broad-based tax on incomes (and/or
consumption) than to introduce a specific tax on one sector (here banking). If, however, there are
severe political constraints on doing that, the calculus is not so straightforward: there are
difficult choices to be made.
But is there a tax at all? Arguably the banking market is itself not competitively efficient, so that
full remuneration of reserves might not be passed through, as Bank Rate rises, to customers (in
higher deposit rates and/or lower loan rates) but go, instead, to equity holders (and managers). In
that case, introducing a tiered-reserves scheme would undo a transfer to bankers and
shareholders rather than impose a tax on banking intermediation. This bears on suggestions that
a reformed reserves regime would be unfair.
49
In the circumstances hypothesised, it is not
obvious why it would be fair for bankers and shareholders to enjoy windfall transfers from the
state for a few years, especially as those transfers would be made while the country was
suffering inflationary shocks that might require Bank Rate to be set at levels designed to bring
economic growth below trend for a while.
Is there evidence to support that hypothesis? Perhaps. Although most of the Bank’s QE
purchases will have been from long-term investment institutions, the counterpart to the banks’
massive increase in reserves balances with the Bank has not been an equivalent increase in the
non-bank financial sector’s deposit balances with commercial banks. Instead, with QE’s effects
transmitted into the wider economy, there has been a big increase in the bank deposits of
households and non-financial businesses.
50
To the extent that those deposits are held in non-
interest-bearing current accounts, and are sticky, when Bank Rate rises the banking industry
earns more (prospectively a lot more) on its reserves without paying out any more on its
customer deposits.
51
Nor can it be argued that, given the prudential regulatory regime, QE fills up banks’ balance
sheets with low-return reserves, depriving them of the capacity to put on higher-return assets.
49
See the quotes from market participants in https://www.bloomberg.com/news/articles/2022-09-21/uk-looks-at-qe-
change-to-avert-10-billion-payout-to-banks.
50
Since QE began in 2009, household deposits have grown by 79% (from £901 billion to £1,616 billion); non-
financial business deposits have grown by 119% (from £365 billion to £797 billion); non-bank financial institution
deposits have fallen by 31% (from £650 billion to £450 billion); and within the financial sector, pension fund and
life-insurance company deposits have grown by 19% (from £52 billion to £62 billion). Since the pandemic-induced
£440 billion increase in QE during 2020-21, the equivalent figures are 19% (households, from £1,362 billion to
£1,615 billion), 23% (non-finance business, £646 billion to £797 billion), minus 4% (non-bank finance,
£468 billion to £450 billion) and minus 4% (pension funds and insurance, £64 billion to £62 billion). Source: Bank
of England data series TDDU, TDDG, TDDR, TDDT, Z945 and TDCA.
51
This endowment effect might reflect competitive conditions in retail banking, but that lies beyond the scope of this
chapter.
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Quantitative easing, monetary policy implementation and the public finances
That is because the Bank has excluded reserves from the definition of ‘total assets’ in the
regulatory leverage ratio (which caps assets relative to equity).
52
Assessing whether, and how far, there is currently a transfer or, if remuneration were curtailed,
prospectively a tax requires a deeper analysis that the authorities would usefully conduct if they
were to contemplate reform. Indeed, the aim here has been to articulate how the considerations
of public-finance efficiency interact with government’s other concerns and constraints. In the
remainder of the section, we sketch whether the possible reform would harm the banks (quite a
different matter from the efficiency of banking intermediation), and the implications for macro-
financial conditions.
Impact on the banks and financial stability
During the decade Bank Rate was very low, the income to the banks from remunerated reserves
was obviously also low. Assuming all reserves had been held by the main UK banks, interest on
reserves accounted for just 0.7% of their total revenues, and 2.7% of aggregate net profits,
during 2021.
53
Those numbers would become much larger if reserves continue to be remunerated while Bank
Rate rises – certainly to well above zero and probably, given the various inflationary shocks, to
materially above its neutral level.
Quite apart from how any tax affects allocative efficiency (see above), which is for the Treasury
to consider, the Bank would need to evaluate whether introducing unremunerated reserves –
even if thought of as removing a transfer – would damage the banks’ underlying earnings, their
market worth, or worse.
54
Could it undermine their capital adequacy, or even their stability? This
is an immensely difficult judgement to reach from outside. While the Bank has in recent years
been consistently reassuring about the resilience of the UK banking system, some expert
52
And reserves are given a zero weighting in the risk-weighted capital ratio.
53
For 2020, because Bank Rate was temporarily increased to 0.75%, and bank profits were lower, the equivalent
figures are 1.3% and 12.6% respectively. This is based on data for the Bank of England’s definition of monetary
financial institutions (roughly speaking, banks and building societies with permission to accept deposits in the
UK). The calculation is based on an estimate of the interest paid (at Bank Rate) on the stock of QE over 2020 and
2021, and reported total income and pre-tax profits for each of those years, using table B3.2 of Bank of England
‘Bankstats’ (https://www.bankofengland.co.uk/statistics/tables). An alternative calculation, using the reported
return on assets for UK banks (source: Bank of England countercyclical capital buffer core indicators), and the
reported total sterling assets for those banks (‘Bankstats’ table B1.4), implies that interest on reserves accounted
for around 3.0% of aggregate profits in 2021.
54
That seems to be the spirit of some sell-side equity analysts predicting lower earnings than otherwise if the reserves
regime were reformed. See, for example, Jonathan Pierce of Numis Securities, note to clients on 28 September
2021 and 14 September 2022, and associated media coverage (e.g.
https://www.bloomberg.com/news/articles/2022-06-20/boe-may-seek-to-recover-qe-losses-from-banks-uk-analyst-
says).
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commentators have argued that capital requirements were, in fact, relaxed a few years ago;
others that they were never high enough; and others still (including this author) that we just do
not know the de facto requirements (because data are not published, even on an anonymised
basis), since they are determined by a combination of regulatory changes and discretionary
micro-supervisory adjustments.
55
The Common Equity Tier 1 (CET1) capital of large UK banks was £447 billion, as at 2022Q1.
56
Plainly forgone income of around £40 billion per year (see Section 7.3) would be large relative
to the banking industry’s capital base. Forgone income is, however, not the same as a loss. So
the argument here against reform would have to be along the lines that the banks needed the
income on reserves to sustain them through stagflationary shocks or other severely adverse
scenarios (perhaps related to the apparent build-up of leverage outside banking). Given the
Bank, as prudential authority, has private information about the state and prospects of the banks,
we have to leave this as a matter for it to weigh when deliberating whether and how to introduce
a tiered-reserves regime.
Passing on the effects and its monetary implications
The big question for macroeconomic policy lurking here is how the banks would pass on the
effects of lower incomes. If any reserves requirements were determined by banks’ pre-
announcement history, there is a question of whether the cost to banks would be sunk, not
affecting their ongoing behaviour at all. Quite apart from the reluctance of business people to
recognise sunk costs, there are reasons for thinking that banks’ behaviour would be affected by
switching off the interest currently paid on reserves. That is because the measure would affect
banks’ realised net interest margin – broadly, the difference between the rate earned on assets
minus the rate paid out on liabilities – for a few years (broadly, until QE runs off). That margin
would narrow, as the average rate earned on assets would fall.
Technically, how the banks sought to pass that on would depend on the relative elasticities
(sensitivities) of banking’s supply of loans and deposits and of customer demand for loans and
for deposits. It seems likely the supply of banking services is more elastic than demand, since
banks’ behaviour is motivated by a drive for profits not by need. If so, banks could seek to
mitigate the hit to currently expected revenues in essentially two ways: by passing on the cost to
borrowers, or to depositors.
55
For the first and second, see Vickers (2016). For the second and third, see Tucker (2019).
56
Source: Bank of England, banking sector regulatory capital 2022Q1. It is vital to focus on tangible common equity,
because only that can absorb losses in a going concern. Intangibles such as goodwill and deferred tax assets are
only worth anything if a bank survives into the future. And subordinated bonds, which can be bailed in during a
resolution, might offer reassurance to uninsured senior creditors but not to equity holders (and one hopes not to the
bankers themselves). Separately: for some banks, market-based measures of capital are lower than book values.
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38
Quantitative easing, monetary policy implementation and the public finances
Either way, the spread between lending and deposit rates would widen: the cost of banking
intermediation would rise. For those monetary economists who believe that the supply of broad
money matters to the outlook for nominal growth and inflation, this would be equivalent to a
contractionary shock to the supply (by commercial banks) of broad money.
At a more granular level, the MPC would need to make judgements about where the adjustment
would fall, how the saving/spending of those on whom it fell would be affected, and whether the
higher cost of banking intermediation would create incentives for disintermediation into the non-
bank financial sector (with possible attendant stability risks).
57
On the first, by way of
illustration, if, say, depositors are least likely to move outside the system, then the burden would
be more likely to fall on them. But if they are already receiving the minimum possible (zero)
and, in UK conditions, cannot easily be charged fees, then borrowers would pick up the burden.
Whether falling on depositors or borrowers, however, there would be both income effects and
substitution effects (incentives to change the time profile of saving/spending choices).
58
The net
effect would need to feed into MPC members’ choices on the path of Bank Rate.
While the Bank of England’s policy committees would have to form views on all these things, it
could not be sure in advance that they were right. It would be able to monitor developments via
its quarterly surveys of credit conditions and banks’ liability conditions, with the committee
updating their views and policy settings accordingly.
59
7.7 Zero remuneration and the political
economy of central bank independence
There is another, quite different kind of consideration: whether changing the reserves regime
would interfere with Bank of England independence.
57
That would matter for financial stability policymakers – in the UK, the Bank’s Financial Policy Committee – if the
slack were picked up by shadow banks (but those issues are not pursued here, since they are merely a subset of the
risks created by the lack of a general policy regime for shadow banking).
58
Whether the pass-through is to depositors or borrowers, the income effects work in the same direction: lower
incomes. But if income effects are dominated by substitution effects, it matters greatly whether banks passed the
tax through to depositors or borrowers. If the whole cost were passed on to borrowers in higher loan rates, credit
conditions would tighten, and the monetary authority could offset the effect of that on the economy by setting a
lower policy rate than otherwise. If, by contrast, the whole cost were passed on to depositors via lower deposit
rates, that would give them incentives to save less and spend more (or to invest in other investments, pulling down
the market rate of interest). The monetary authority might then need to set a higher path for the policy rate than
otherwise.
59
See Bank of England, Credit Conditions Survey 2022 Q1 and Bank Liabilities Survey 2022 Q1 for recent
examples.
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Various arguments have circulated bearing on this. It is sometimes suggested, for example, that
the decision over remunerating reserves is ‘fiscal’ and so for HMT not the Bank. That is too
strong to the point of being incorrect. The fiscal authority cannot determine the monetary
operating regime without overriding monetary independence. As already noted, when interest-
on-reserves was introduced, that was a Bank initiative. But, reflecting the kind of tax
considerations aired in the previous section, HMT was consulted and given an opportunity to
object.
60
Conversely, it is also sometimes suggested that independence would be violated if HMG were
even to ask the Bank to consider a change. That too is not so. This is partly because, as outlined
in Sections 7.4 and 7.5, other operating systems could be viable. More generally, it is reasonable
for Bank and Treasury to coordinate on the design of monetary and debt-management regimes so
long as an independent MPC is still free to decide the stance of monetary policy (in the light of
its statutory mandate), and provided debt management does not interfere with that. Such a norm
was included in the government’s objectives for debt management when monetary independence
was introduced.
61
It found expression in the early-2009 public exchange of letters between then
Governor Mervyn King and then Chancellor Alistair Darling to the effect that, among other
things, HMT would not change its debt-management strategy to exploit the effects of QE on
long-term gilt yields, thereby undoing some of its effects. (Not all advanced economies achieved
the same concord.)
62
Notwithstanding the importance of correcting those misperceptions, there does remain a risk to
independence from moving to interest-free reserves. This arises because if the bulk of reserves
received no remuneration, the government would have incentives to push for more QE (fleshed
out below). Although, as discussed in Section 7.3, there was a sizeable opportunity cost in HMG
not being financed via long-term fixed-rate bonds when long-maturity forward rates were
unusually low, it needs to be underlined that such funding would still have been more expensive
than completely free financing from the Bank.
What pressure government could bring to bear on the Bank is unknowable. But, with
unremunerated reserves, where monetary policy needed to be loosened HMG would
presumptively prefer the Bank doing so via QE rather than cuts in the policy rate; and
60
Disclosure: I was the Bank of England official who handled that when remunerated reserves were introduced in the
early-to-mid 2000s.
61
The government’s objective for debt management, which has not substantively changed since the 1997–98
monetary reforms, is (with my emphasis): ‘to minimise, over the long term, the costs of meeting the government’s
financing needs, taking into account risk, while ensuring that debt management policy is consistent with the aims of
monetary policy’ (HM Treasury, 2021, paragraph 3.20).
62
Chancellor of the Exchequer Alistair Darling’s letter of 3 March 2009 to Governor Mervyn King stated that: ‘the
Government will not alter its issuance strategy as a result of the asset transactions undertaken by the Bank of
England for monetary policy purposes’. On the US, see Greenwood et al. (2014).
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Quantitative easing, monetary policy implementation and the public finances
conversely, it would prefer monetary tightening to come via increases in the policy rate rather
than sales of gilts.
QE, the zero lower bound, and the political economy of inflation
targeting
In assessing the various macro-finance risks attendant upon QE discussed in this chapter – the
public-finance risk exposure arising from paying Bank Rate on reserves, and the risk of
governments pressing the Bank to prioritise QE if reserves were not remunerated – it matters
how frequently the Bank is likely to find itself in a position of wanting or needing to stimulate
the economy via QE. This is related to two things: the likely average nominal rate of interest,
which affects the likelihood of the central bank’s policy rate reaching whatever is judged to be
the effective lower bound; and the central bank’s preferred response if it does approach that
point. If, as Bank of England work implies, the British nominal rate of interest will average 2%
or so over the medium-to-long run (so long as the inflation target remains at 2%; see Section
7.2), then it is likely the effective lower bound will be hit much more frequently than when the
inflation-targeting regime was introduced in the 1990s.
Big picture, there are then three options for providing extra stimulus to aggregate demand:
greater reliance on fiscal stimulus, the Bank setting negative interest rates (i.e. relocating the
effective lower bound), and QE. Since no central bank has contemplated setting negative rates
much beyond minus 50 basis points, there is a zero/effective lower bound (ZLB) problem for
macroeconomic policy. Revealed preference accordingly leaves fiscal stimulus and QE as the
realistic choices. Here, however, we encounter an important strategic interaction between elected
fiscal policymakers and unelected monetary policymakers. Since the fiscal authority is not under
a legal obligation to act, elected policymakers can afford to sit on their hands knowing that the
central bank will strive to do more to meet its inflation target.
63
Quite apart from the various political costs – from donors or other core backers – that an elected
politician potentially pays in undertaking almost any discretionary fiscal action, politicians
would have even more reason to do nothing if infra-marginal reserves were not remunerated,
because the central bank resorting to QE would deliver free funding. In other words, the
combination of a low equilibrium real interest rate and zero interest on the bulk of reserves
makes it more likely that QE ends up being the instrument of choice whenever the standard way
of providing monetary stimulus is constrained by the zero (or effective) lower bound.
63
In game-theoretic terms, this has the characteristics of a Stackelberg game, in which moves are sequential and that
matters. Here, because the monetary policymaker has legal objectives to meet, the first mover is the less
constrained fiscal authority. See Tucker (2018, pages 535–536).
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By contrast, whenever the long-maturity forward rate is meaningfully below most views of the
equilibrium nominal rate of interest, paying the policy rate on reserves would rationally shift a
long-sighted fiscal policymaker’s incentives towards favouring debt-financed fiscal action,
rather than QE, at the zero lower bound. That things did not play out that way in 2020 and 2021
is therefore a significant puzzle. Did government effectively make a mistake, not understanding
its own longer-term interests, with the implication that, having learned lessons, in future the
Bank paying interest on reserves would tilt government towards favouring debt-financed
expenditure in otherwise-similar circumstances? Or does an elected government have only weak
incentives to weigh the costs of interest-on-reserves, because ministers might not expect to be
serving if and when the risks of floating-rate funding crystallise? Or are the political attractions
of not being exposed to the vicissitudes of market finance so powerful that, somehow, the central
bank is induced into conducting QE even when fiscal measures would better be funded in the
market (as in 2020–21)?
The answers are unclear, pressing the issue of whether there are ways of materially reducing the
incidence of the ZLB problem, and so reducing the likely incidence of QE. One such option
would be to raise the inflation target, and thus the equilibrium nominal rate of interest. The
arguments for and against this lie beyond the scope of this chapter, except to note that it would
be easier to make any such change from a position of strength (inflation in line with the existing
target).
Another option for mitigating the ZLB problem would be for parliament to strengthen the
existing automatic fiscal stabilisers, so that they kick in more powerfully in the face of big
adverse shocks to aggregate demand. Putting a turbocharged fiscal policy for severely adverse
conditions on something more like autopilot might mitigate the strategic hazards (above) of not
remunerating the bulk of reserves balances with the central bank, but would introduce other
issues. One concerns the prudent level of debt-to-GDP if the fiscal authority is even more
certainly the insurer of last resort against economic slumps. Another is the fraught partisan
political question of what distributional choices to encode into such turbocharged automatic
fiscal stabilisers.
Summing up, moving to a reserves regime incorporating unremunerated reserves would add to
fiscal policymakers’ incentives to press for QE, rather than act themselves, when the central
bank policy rate is at its effective lower bound. Assuming that the UK wishes to buttress central
bank independence, this points to introducing some codified constraints on de facto monetary
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Quantitative easing, monetary policy implementation and the public finances
financing of government, except in emergencies, if the Bank moves to an operating regime that
64
includes unremunerated reserves.
Reserves-regime stability and central bank credibility
A quite different kind of political economy consideration is whether changing the reserves
regime would lead bankers and others to conclude that any new regime might itself be subject to
future changes. In other words, would people expect instability in the Bank’s sterling monetary
framework?
At the least, if the Bank were to change the current system before the current QE-created
reserves had run off, it would need also to announce how the system would operate in future. For
example, it could say that when there was no QE, it would employ voluntary reserves averaging
(see Section 7.4) with full remuneration of reserves, but that it would flip to a tiered system, with
zero interest paid on the bulk of the stock of reserves, whenever it employed QE.
That uncertainty counts as a reason – not in our view decisive but certainly to be weighed – for
not making a midstream correction to the reserves-remuneration regime, leaving the current
public-finance risk exposure intact. But even then, subject to HMT’s position on the important
tax-regime points summarised in the previous section, the authorities ought to avoid a similar
risk exposure arising in the future. So, part of a contingency plan for whenever QE is employed
in future would include moving to tiered reserves along the lines described, or alternatively to
some other scheme that would avoid unnecessarily transforming the state’s risk exposure.
7.8 Other possible remedies
Accordingly, this section briefly looks at two other options.
The NIESR swap proposal
As noted earlier, one suggested remedy was advanced during 2021 by the National Institute of
Economic and Social Research. Broadly, it proposed the bulk of the banks’ reserves be replaced
with a portfolio of short-term gilts. From the perspective of the banks, this would continue to
provide liquid assets (like reserves), and would continue to provide a return (like remunerated
reserves), and it would do so without exposing the banks to the price risks of holding longer-
term gilts. From the perspective of the state, meanwhile, the public finances would be less
64
This would obviously need to be drafted with great care. Following the UK’s exit from the EU, it is no longer
subject to the Maastricht Treaty bar on monetary financing. While the Maastricht Treaty exempted the UK from
having to join the European Monetary Union, the UK signed up to an obligation in international law not to permit
monetary financing.
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exposed to unexpected short-run movements in Bank Rate since two-year fixed-rate funding
terms would be locked in.
More precisely, NIESR proposed that the state hedge its exposure to unexpected rises in Bank
Rate by substituting two-year gilts for around two-thirds of banks’ reserves. The banks pay for
the short-maturity gilts by running down their reserves (their bank balance) at the Bank. At a
consolidated level, the state replaces floating-rate borrowing with funding at a rate fixed for two
years.
65
NIESR has the Treasury and Bank negotiating with the population of reserves banks the
prices at which they would exchange reserves for gilts. But that is not essential to the core of the
proposal, as an auction could be used rather than a person-to-person negotiation.
More important is whether, to date, it would have saved or cost money. The two-year gilt yield
at the time NIESR published its proposal was roughly 0.1%. In mid 2022, by which time there
had been increases in both Bank Rate and market expectations of its future path, NIESR issued a
statement on how much it had cost the government not to substitute two-year gilts for reserves
when recommended.
66
Assuming the two-year gilts could have been issued at the then prevailing
yield (0.1%), the cost was around £11 billion over the two years.
67
(Today, the number would be
much larger, but see below.)
HMT responded by pointing out that the two-year gilt yield would have risen, perhaps sharply,
had so much stock been issued at once.
68
Although qualitatively fair, this risked obscuring the
65
Mechanically, the following happens: the Bank’s APFF and the UK Treasury’s Debt Management Office (DMO)
enter into a transaction under which the APF vehicle exchanges some of the gilts it holds for the gilts that will be
sold to the banks; when the banks buy the gilts, they run down their reserves balances at the Bank’s Banking
Department to do so; and the APFF uses the proceeds to repay its loan to Banking Department. The balance sheets
of Banking Department and the APFF both shrink by the same amount. HMG has more short-term gilts in issue to
the market, while the gilts acquired in exchange from the APFF can either be cancelled or be held by the DMO for
subsequent sale. Substantively – and this matters to some of the points made in the main text – this is equivalent
economically to the following: the DMO auctions two-year gilts to the banks; the banks pay by running down their
reserves accounts with the Bank’s Banking Department; the DMO uses the proceeds of the auction to purchase the
APFF’s gilt portfolio (which the DMO can then cancel or hold for resale); and the APFF uses the proceeds of its
sale to the DMO to repay its loan from Banking Department. My alternative mechanics highlight (a) the possibility
of the negotiation with the banks being conducted via an auction and (b) the possibility, if new gilts are to be
auctioned, of auctioning a full range of gilts to the market as a whole (discussed in main text below).
66
See Allen, Chadha and Turner (2021) for original research paper, and NIESR (2022) for subsequent commentary.
Disclosure: I am the president of NIESR and so a trustee, but I was not involved in this paper.
67
Two years had not passed so the estimated opportunity cost from not hedging in the proposed way was the sum of
funding at (the evolved path for) Bank Rate until mid 2022 and via a one-year gilt issued in mid 2022. The
differences in media headline on the savings from NIESR (£11 billion) and NEF (£57 billion) are explained by
three things: NIESR flips only £600 billion not, like NEF, the full stock of reserves into a lower-yield asset; NIESR
assumes a two-year gilt paying 0.1% whereas NEF assumes unremunerated reserves; and NIESR calculates
savings over two years whereas NEF does so, looking forward, for three years. The last, which accounts for the
lion’s share of the difference, matters only to the extent that the NIESR hedge has to be rolled over and so is
exposed to uncertainty (see main text).
68
‘The proposals are complicated and involve forcing banks to swap reserves for longer-dated securities, but the
£11 billion figure itself is based on almost impossible scenarios and implementing the proposals would have a
significant impact on market prices and credibility’ (John Glen MP (then Economic Secretary to the Treasury),
Twitter, 10 June 2022, https://twitter.com/JohnGlenUK/status/1535203397028265984).
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Quantitative easing, monetary policy implementation and the public finances
underlying point. First, just on the arithmetic, the yield-at-issue on the proposed two-year gilts
would have needed to rise by somewhere between 90 and 100 basis points for there to be no ex
post cost saving for HMT. That is a lot for a frictional and so temporary supply effect. Second,
in operationalising the NIESR proposal, it would not have been necessary to auction the whole
amount on one day. Auctions could have been spread over a period, with forward settlement
dates, so as to cater for the possibility of market indigestion. Indeed, one would want to consult
auction-theory experts on how best to do this, including whether to conduct single-price auctions
(so as to avoid issuing at a discount to fair value by imposing the winner’s curse on the highest
bidder). In other words, without endorsing the NIESR proposal, it seems difficult to dodge the
conclusion that, as things happened to turn out, HMG would have made a significant saving had
it hedged some of its interest-rate exposure in the way NIESR proposed when it proposed it.
To be clear, a saving was not absolutely certain: conceivably, if the economy had been hit by
further adverse shocks to aggregate demand, Bank Rate might have been set at a negative rate.
But we judge that a saving to date was highly likely given the balance of risks to inflation
emerging during 2021 (when NIESR published its proposals).
In any case, NIESR’s specific proposal was (and is) not remotely the only way of effecting its
broader proposal that HMG hedge the state’s exposure to the short-term path of Bank Rate.
Among many other possibilities, HMG would probably have done well ex post if it had bought
options to sell gilts at the yields prevailing in mid 2021 (when the Bank of England still seemed
to signal that the rise in headline inflation would be ephemeral and so Bank Rate would hardly
need to be raised). That is because both the realised and option-implied volatility were low then
(arguably another effect of sustained QE purchases). While all these options – NIESR’s, and
others – would look like government trading its own debt (generally unwise), they would
amount to responses to the Bank’s interventions in the gilt market having changed the state’s
debt structure. So one question is whether, given QE’s goals and its transmission into the
economy, MPC members would feel that any HMG hedging would risk undermining their
monetary policy interventions or, more seriously, the chances of delivering inflation in line with
the 2% target.
Arguably a more serious point on NIESR’s specific idea is that if the gilts substituted for
remunerated reserves (or any bought option) had an average maturity of around two years, the
hedge would not cover the risk of an extended series of upward shocks to the expected path of
Bank Rate, which could adversely affect government refinancing costs when the new two-year
gilts matured. Plainly, as already discussed, recent events have underlined the materiality of that
risk exposure.
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The Bank simply selling its gilts: the significance of risk premia to
QT and government debt management
Both that last consideration and the intricate mechanics of the NIESR proposal (see footnote 65)
point to another option. In essence, NIESR’s proposal has the government draining reserves by
issuing extra short-term gilts to the banks. But, at least in normal circumstances, perhaps better
prices and a more balanced liability portfolio could be achieved by draining reserves via issuing
extra gilts with the full range of types and maturities to the market as a whole. Once that thought
is admitted, another comes into view: that the Bank simply sell its gilt portfolio to the market. In
other words, there is an option of adjusting monetary policy primarily by unwinding QE rather
than leading with increases in Bank Rate.
That is not to argue whether QT or Bank Rate should be the primary instrument for tightening
monetary conditions – a choice for the independent MPC – but, rather, to highlight that this
possible course exposes other issues, one running deeper than can be addressed here.
Selling off the APFF gilt portfolio would likely crystallise losses (as nominal yields would have
risen if either the economy was recovering or it had been hit by inflationary shocks). If the Bank
called upon the Treasury Indemnity to cover those losses (Box 7.1), monetary tightening via QT
rather than by raising Bank Rate would simply hit the public finances via a different route. Put
another way, the yield at which gilts are sold or resold to the market reveals and crystallises the
opportunity cost of the government having effectively funded itself via QE; and that opportunity
cost – reflected in a capital loss at the Bank – becomes a realised loss for central government
when the Treasury Indemnity is called upon.
This raises the question of whether, instead, the Bank could refrain from calling the Indemnity,
carrying the realised loss on its own balance sheet. For some, it is a deep question in monetary
economics (beyond the scope of this chapter) whether, in general, it is economically feasible for
a central bank to operate with negative equity in accounting terms where it has prospective
offsetting future profits not reflected in its accounts.
69
For others, the pressing practical question
is one of political economy: whether a loss-making central bank would be more vulnerable to
political influence through the process to effect, and through the public debate prompted by,
recapitalisation.
Putting the indemnity question aside, a more practical risk-management issue remains. If the
Bank sold into a market that was charging a risk premium on gilts (over and above the expected
path of Bank Rate over any gilt’s remaining term to maturity), it would be cheaper for the state
69
There is also the question of whether, in particular, the Bank of England could do so given the laws to which it is
subject.
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Quantitative easing, monetary policy implementation and the public finances
to fund from the Bank at Bank Rate.
70
Whereas it can be worth paying a term premium in order
to spread the maturity profile of the public debt (and so avoid rollover risk not only in the near
term but in the more distant future), paying (or, via QT, crystallising) any default-risk premium
is a different matter if the authorities have good reason to believe that it will almost certainly go
away.
At the time of writing, that problem might seem pertinent, perhaps suggesting that, whatever the
monetary policy arguments for QT, the public finances might be better off if any monetary
tightening is delivered by increases in Bank Rate rather than by QT. We reject that reasoning for
two reasons. First, to date, it is not clear that a default-risk premium has, in fact, entered into gilt
yields. The startling rise in long-maturity forward rates was amplified by forced selling of long-
maturity gilts (especially inflation-indexed gilts) by overleveraged and illiquid pension-scheme
vehicles. Yields were brought down – at least initially – by Bank of England market-maker-of-
last-resort operations.
71
More important here, even at the early extremity of the rise in long
forward rates, there was little to no sign of higher medium-term inflation expectations and an
inflation risk premium widening the wedge been nominal and real forward rates (Figure 7.8),
even though that is exactly what one would expect to see if the market attributed a tangible
probability to default risk, since monetisation to relieve the real burden of the debt would surely
be much more likely than legal default.
72
(Of course, that could change.)
Second, on the possible inference for policy, even were a default-risk premium to appear in gilt
yields, it would surely be more appropriate for the DMO to adjust the profile of its gilt issuance
– in the light of, among other things, the term structure of the default premium – than for the
70
This is because QE purchases followed by QT sales amounts, in public-finance terms, to the government
borrowing at a floating Bank Rate until the sale, but at the yield-at-sale for the bond’s remaining term. If that yield-
at-sale includes a material risk premium (for the risk of sovereign default or of avoiding default by monetisation),
continuing to fund at Bank Rate should be cheaper so long as the risk premium is unwarranted.
71
Following the government’s budget statement on Friday 23 September, announcing various tax cuts and other
fiscal measures but not articulating a medium-term fiscal framework, the yield on UK gilts rose sharply and
sterling’s exchange rate against a basket of currencies fell sharply. The combination is unusual. Typically,
whatever its effects on the economy’s productive capacity over the medium term, fiscal stimulus propels aggregate
demand, requiring a higher path for the monetary policy rate to achieve the inflation target, leading to an
appreciation in the exchange rate. That will not be so, however, if, for whatever reason, the market concludes that
the public-debt burden might not be sustainable over the longer run, creating a tangible (if still small) probability of
default. On the Bank’s MMLR operation and frictions in the gilt market, see Deputy Governor Cunliffe’s letter to
the chairman of the House of Commons Treasury Select Committee (Mel Stride MP), 5 October 2022,
https://committees.parliament.uk/publications/30136/documents/174584/default/. Unfortunately, the Bank did not
sterilise the consequent injection of reserves, making it seem to some commentators like the resumption of QE,
despite the Bank’s assurances.
72
For a further discussion, see Tucker (2022). Whether long yields rise sharply again when the Bank steps back will
reveal, among other things, whether effective measures have been taken to ameliorate the strains in this part of
leverage finance; like the perhaps more familiar lender-of-last-resort (LOLR) operations, market-maker-of-last-
resort operations sometimes simply buy time to fix the underlying problems. On 10 October, the bailout became
more targeted when the Bank announced expanded LOLR facilities for the banking industry to backstop banks
providing liquidity to the liability-driven investment (LDI) industry. That too buys time for repair and adjustment
in the funds.
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MPC to substitute its own view by postponing QT and raising Bank Rate more sharply than
otherwise.
In principle, those arguments leave intact the option of the MPC accelerating the pace of QT,
and correspondingly slowing the rise of Bank Rate, in order to bring about whatever degree of
monetary tightening it desires while reducing the stock of reserves and so the part of public debt
that is effectively floating rate. Actually choosing that course would depend upon whether MPC
members were broadly indifferent between the balance of QT and rate rises in terms of their own
objective, and any feedback from HMT on public-debt-structure considerations and possible
supply effects on yields.
Figure 7.8. Ten-year and thirty-year inflation spot rates (break-evens)
5
4
3
Per cent
2
1
0
10-year 30-year
Mar 2022
Apr 2022
May 2022
Jun 2022
Jul 2022
Aug 2022
Sep 2022
Oct 2022
Note: Data run to 6 October 2022.
Source: Bank of England.
7.9 Conclusion
This chapter has attempted to unravel the mechanics and economics lying behind recent public
debate about the costs and risks to the public purse from government having borrowed vast
amounts at a floating rate of interest through a combination of the Bank of England’s
quantitative easing purchases of gilts and its paying the short-term policy rate of interest on
banks’ reserves balances.
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Quantitative easing, monetary policy implementation and the public finances
Even if all the Bank’s gilt holdings were to be sold off quickly in the coming period, so that the
British state’s risk exposure to short-term interest rates goes away for the time being, the issues
covered in the chapter demand serious discussion so that similar risk exposures and opportunity
costs do not again inadvertently arise whenever QE is conducted in the future. That is not
hypothetical. First, given the proximity of most current estimates of the equilibrium nominal rate
of interest to zero, the lower bound is likely to bite, and QE to be deployed, much more
frequently than when the UK’s current monetary regime was established. Second, even without
any ZLB constraint, if the Bank resorts to purchasing gilts for other reasons but does not sterilise
the injection of base money, the problem of fully remunerated reserves for the public finances
will recur. Since a central bank should routinely sterilise such operations, we do not pursue that
here.
73
Going more slowly, we can now unravel the tangle of issues flagged in the introduction. Because
the world equilibrium real rate of interest has been so low, it has become likely that the central
bank policy rate will reach zero much more frequently than anyone contemplated 20 years ago.
Because central banks are reluctant to embark on the even greater leap into setting large negative
interest rates, whenever their rate is stuck at (or near) the zero lower bound, they are likely to
want to turn to QE, injecting more reserves into the monetary system. Because central banks
have remunerated the totality of reserves at (or close to) their policy rate, the structure of the
state’s debt is thereby swapped from being fixed rate to being floating rate. Because the
economy has been hit by various inflationary shocks, having floating-rate obligations looks set
to impose a nasty hit to the public finances.
That risk exposure will persist if things remain as they are. Any solution would have to break
one or more of the links in the explanatory chain. The first and fourth – low global real rates, and
inflationary shocks – are open to action (and therefore hope), but cannot just be swept away, as
they reflect matters largely beyond the control of UK governments. If low equilibrium real rates
owe something to low underlying growth and to an ex ante excess of global savings over
investment, and if nasty inflation shocks are down to wars, pandemics and monetary policy
hesitation, policymakers can pursue remedies but they cannot be sure of succeeding. Finding a
domestic way of breaking the chain’s second step would, instead, entail either raising the
inflation target (perhaps not the easiest moment for that in terms of the monetary regime’s
credibility), or codifying stronger automatic fiscal stabilisers into law (which could, however, be
changed down the road – if ever they were agreed). This leaves the third link in the explanatory
chain – the restructuring of the state’s debt by remunerating the totality of banks’ reserves at
73
This goes for lender-of-last-resort and market-maker-of-last-resort interventions. In normal circumstances,
voluntary reserves averaging would necessitate sterilisation. If the special operations were conducted while QE
was outstanding and so the standard operating system had been suspended (as now), there should still be
sterilisation unless the MPC expressly approved the injection of more base money. See, for various different
purposes of buying government bonds and their implications for governance, Cecchetti and Tucker (2021).
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Bank Rate – which, if broken, would be distinct in so far as it should be robust (invariant to
future bad states of the world).
The headline message of the chapter is, therefore, that the current predicament is not
unavoidable. It would be possible for the Bank to operate monetary policy with a system of
tiered remuneration for reserves balances; and reasons exist for doing so when the Bank is
imposing the quantity of aggregate reserves it supplies rather than, as under voluntary reserves
averaging during normal times, letting each individual bank choose its desired reserves holdings.
The chapter has not recommended that the Bank and Treasury should definitely pursue that
course immediately, because there are weighty considerations weighing on the other side
(Sections 7.6 and 7.7). They concern the effect of taxes on the efficient allocation of resources,
credit conditions, and the political economy of central bank independence. It matters, for
example, whether ceasing to remunerate the bulk of banks’ reserves would amount to a tax on
banking intermediation, or to the withdrawal of transfers to bank bosses and shareholders. It
also matters whether UK public finances are under so much pressure that orthodox stipulations
against a tax on banking carry less force than usual.
There are questions there for both the Treasury and the Bank. It is for the Treasury to weigh the
microeconomic costs of tax and allocative efficiency against the more macro costs and risks to
the public purse from so much of the British state’s debt being floating rate. That effectively
gives it a veto over reserves-regime reform. If, having weighed everything, the government were
to ask the Bank to consider reform, it is for the Bank to decide whether it could do so without
compromising its statutory objectives for price stability and financial-system stability (more
broadly, for monetary-system stability).
If the Bank were faced with that request but did not want to introduce reforms while the current
stock of QE is outstanding, we recommend that a clear contingency plan be articulated for when
these circumstances recur. It seems to this author that, subject to any Treasury concerns about
ill-directed taxes impairing efficiency, the authorities would need good reasons not to plan on
operating tiered reserves (or some better scheme) next time Bank Rate is stuck at zero and the
MPC employs QE as a substitute for further rate cuts.
That reflects a more general observation. Discussions of risk are fraught with difficulty. Scenario
and counterfactual analysis of the kind drawn upon here (Section 7.3) is useful partly because it
helps us get a grip on the question as to whether, if costly thing x happens but could have been
avoided, it is reasonable to feel that it should have been avoided (or at least mitigated); that, in
other words, it is reasonable to criticise government for not avoiding the avoidable. It matters,
therefore, whether a risk scenario is reasonably regarded as far-fetched, or whether a risk is so
imperfectly understood that it is unreasonable to say that it should have been avoided. For the
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Quantitative easing, monetary policy implementation and the public finances
QE-related risk to the public finances, the adverse scenario of the monetary regime adding
materially to the public debt burden has not been far-fetched since at least 2019, and it is not
incapable of being understood (even though, no doubt, this analysis could be improved upon).
Finally, therefore, an important high-level conclusion follows from this chapter’s analysis. Just
as the country’s current macroeconomic regime rightly stipulates that government debt
management (strategy and tactics) should not interfere with the independent MPC’s monetary
policy, so too should central bankers aim to implement monetary policy in ways that least
adversely affect the public finances. That simple statement leaves hanging the awkward matter
of who, given the political incentives of finance-ministry debt managers, gets to judge what
monetary policy techniques interfere too much with the public finances. The best course, we
suggest, would be to put the Bank under that obligation when making choices among options to
which the MPC is otherwise indifferent (i.e. in terms of the implications for monetary conditions
and, hence, the outlook for inflation relative to the MPC’s target). Had an obligation of that kind
existed, public resources could have been saved without impairing monetary-system stability. A
carefully drafted version might usefully be added, together with codified hurdles for monetary
financing, when the MPC Remit is updated.
74
References
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policy from fiscal encroachment. National Institute Economic Review, 257, 1–8.
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Bailey, A., 2022. The economic landscape: structural change, global R * and the missing-investment puzzle.
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Various other proposals for strengthening the Bank’s monetary and financial stability Remits (including cutting
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Cesa-Bianchi, A., Harrison, R. and Sajedi, R., 2022. Decomposing the drivers of Global R*. Staff Working
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Annex. Definitions
To help the reader, some definitions are introduced and briefly explained here. Some are
elaborated in the main text.
Bank rate: see central bank’s policy rate
Base money: central bank liabilities that function as an economy’s most basic money. Under
modernity it has taken two forms: physical notes, and banks’ balances with the central bank
(known as reserves; see below).
Broad money: base money (see above) plus the deposit liabilities of banks (and others) used as
a medium of exchange and store of value by households, businesses and others. There can be
various measures of broad money.
Central bank’s policy rate: the rate of interest that the central bank wishes to prevail in the
market for overnight money. In the UK, this is known as Bank Rate, which is the rate of interest
currently paid on the totality of banks’ reserves balances with the central bank.
Duration of gilt portfolio: the weighted-average term to maturity of the cash flows (coupons
and principal) on the portfolio of gilts outstanding. This affects the sensitivity of the portfolio’s
market value to shifts in market interest rates.
Fixed-rate debt: borrowing at a known, fixed interest rate for the maturity of the loan.
Floating-rate debt: borrowing under terms where the rate of interest charged is periodically
reset according to some pre-agreed process or index.
Forward rate: the interest rate for a future period, implicitly incorporated within spot interest
rates for loans of different maturities. If the yield on an n–1-year maturity gilt is x% and that on
an n-year gilt is y%, the implied one-year forward rate in n–1 years’ time is the rate needed to
deliver the y% n-year yield given the x% n–1-year yield. The instantaneous forward rate at year
n is the implied instantaneous (crudely, one-day) rate of interest in n years’ time.
Gilt: long-standing shorthand for ‘gilt-edged’ (originating in the old paper certificates having
gilt edges) for a bond issued by the UK’s central government. Conveys very low default risk
(which has mainly, but not always, been true).
Gilt yield: the rate of interest rate paid/earned on a government bond. The yield at the point of
issuance is what matters to government, so long as it does not buy back the bond before
maturity. QE entails exactly such a buy-back at the level of the consolidated state.
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Modified duration: a mechanical adjustment to the duration measure, capturing the sensitivity
of a bond’s price to a small change in its yield.
Quantitative easing (QE): the purchase of government bonds (and sometimes other bonds with
very low default risk) in order to stimulate aggregate demand in the economy. QE creates
reserves: the central bank pays with reserves, i.e. by crediting banks’ current accounts. It is not
the case, as sometimes implied by commentators, that banks choose to place the proceeds of
their gilt sales into reserves. In aggregate, the banking system cannot avoid holding the extra
reserves, or dispose of them. Individual banks can attempt to do so, but that merely reshuffles
each bank’s share of the total, with some holding more. QE is part of monetary policy. Not all
central bank purchases of government bonds are QE; they are not QE when undertaken for a
purpose other than stimulating demand by easing monetary conditions (Cecchetti and Tucker,
2021). In those circumstances, the central bank might want to use other transactions to offset the
creation of reserves (often known as sterilisation or draining).
Reserves: liquid deposit balances held by banks (and in principle others) with the central bank
of issue. Reserves are created whenever a central bank pays for an asset or makes a loan in its
own currency. Where only banks have accounts with the central bank, the newly created money
ends up in banks’ reserves accounts, whoever was the central bank’s counterparty for the
underlying transaction.
State’s consolidated balance sheet: the balance sheet (liabilities and assets, actual and legally
contingent) of the sum of all organs of the state, netting out intra-state transactions. For the
purposes of this chapter, what matters is that the consolidated balance sheet nets out obligations
between the treasury and the central bank, leaving only their obligations to and claims on the
domestic private sector and overseas.
Term premium: the extra rate of interest paid on a long-maturity bond to compensate investors
for locking up their funds, or having to accept a discount if they sell their asset in the market
prior to its maturity.
Zero lower bound: the lowest practically feasible level for the central bank’s policy rate of
interest (Bank Rate in the UK). Often this is zero because the central bank does not wish to (or
cannot) set a negative policy rate. Where, for example because of possible adverse effects on
bank lending, the central bank does not wish to go below some positive level for interest rates,
economists refer to the ‘effective lower bound’.
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