Restoring the Bank of England’s compromised independence
The Bank of England is proud of its independence, which since 1997 has allowed it to determine, without interference, the prevailing level of short-term interest rates in pursuit of price stability. Since 2009, it has, however, changed interest rates only once. Its main monetary policy instrument has been quantitative easing, which means the purchase of massive quantities of assets, financed by deposits from the commercial banks.
The total so far is £545 billion: £435 billion of gilts, £100 billion lent under the Term Funding Scheme, and £10 billion of corporate bonds. The capital and reserves of the Bank of England are £4.6 billion, and the leverage ratio of the Bank of England (capital and reserves/total assets) is around 0.8% - a lot less than the Bank of England would tolerate in any commercial bank. So the Bank has asked for, and received, government guarantees against any losses on assets bought in the QE programme (the Treasury gets any profits, naturally). Accordingly, about 95% of the Bank’s assets have a Treasury guarantee.
Of course - as I argue in an article in the latest edition of NIESR’s Economic Review - the need for a Treasury guarantee has compromised the independence of the Bank of England. Every time it has wanted to do more QE, the Bank has had to ask the Treasury to extend the guarantee. No guarantee, no more QE.
There are good reasons for central banks having some degree of independence and it would be wise for the Bank of England to be extricated from the position it is in now. That could be achieved if some of assets that the Bank bought in the QE programmes could be moved off its balance sheet. The £435 billion of gilts are the most liquid of the assets that the Bank has bought, but it would be dangerous and foolish to try to sell them in the market except over a period extending over several years – recall that the Debt Management Office’s annual gilt sales are around £130 billion. They could, however, be transferred to the Debt Management Office in exchange for newly-created Treasury bills, which the Bank could sell over a period of several months. In that way, the Bank’s balance sheet could be reduced in size to about £130 billion and its leverage ratio increased to a more respectable 3.5%. The commercial banks would hold far more Treasury bills among their liquid assets, and far fewer balances with the Bank of England.
There would be two incidental but important consequences. First, the Bank’s method of controlling market interest rates would have to change. At present, if the Bank wants to alter interest rates, it merely alters the rate it pays on deposits placed with it by the commercial banks. If their balances with the Bank of England were smaller and their Treasury bill holdings larger, the Bank of England would need to revert to an older method of managing short-term interest rates, involving bill purchases in the money market.
Second, the eventual unwinding of QE – at least its gilt-edged component – would be under the control of the DMO, and not the Bank of England. This might not be welcome to the Bank, since it regards QE as a monetary policy instrument. Yet there is absolutely no difference in substance between the Bank of England selling gilts for monetary policy purposes and the DMO selling them to finance the government. And selling exceptionally large quantities of gilts is likely to put a strain on market liquidity and will therefore be a delicate operation, better conducted by a single official seller, the DMO, than by two separate sellers, between which co-ordination would inevitably be less than perfect. The DMO would have to tell the Bank of England what its plans were in advance, so that the Bank could adapt its short-term interest rate policy as necessary.
Once reduced in size, the Bank of England would no longer need indemnities from the Treasury. It should be allowed to retain enough of its profits to maintain and perhaps increase its leverage ratio, enabling it to resort again to the use of its balance sheet if the need should arise.