Quantitative Tightening: Protecting Monetary Policy from Fiscal Encroachment – One Year On

Governments in many countries are ill-prepared for a long period of higher inflation and rising interest rates.  Quantitative Easing (QE) meant that a significant part of official debt (government and central bank combined) took the form of commercial bank deposits at the central bank (bankers’ reserves). When policy rates were close to zero, this was a very cheap form of finance. But the policy had the drawback of making official interest rate payments more sensitive to changes in policy interest rates, perhaps tempting governments to put pressure on the central bank to “go easy” on interest rate hikes.

The United Kingdom is one case in point. In July 2021, bankers’ reserves at the Bank of England had reached £840 billion, and were still rising. As an insurance policy against such fiscal risks, and to protect the independence of monetary policy, we recommended that the Treasury undertake a large-scale swap of bankers’ reserves at the Bank of England for newly-issued short- and medium-dated fixed-interest government securities.

This would have achieved two objectives in a single operation:

1. It would have begun the process of reversing quantitative easing, thus helping to contain the inflationary pressures that were by that time clear; and
2. It would have given the government some insurance against the cost of rising short-term interest rates.

The authorities did not act promptly on our recommendation. The Bank of England’s Monetary Policy Committee has begun to respond to rising inflation, by increasing short-term interest rates. However, by not undertaking the swap that we recommended, the monetary and debt management authorities missed the opportunity to buy interest rate insurance when it was unusually cheap.  In July last year, two-year gilt yields were no higher than 0.10%.

The interest rate insurance that the government could have bought in July 2021 has now become much more expensive — we estimate the loss over the past year at around £11 billion.[1]  Such a lost opportunity is an unnecessary cost to the public finances at a very difficult time.

This calculation takes no account of the mark-to-market losses on bonds held by the Bank of England under its Asset Purchase Facility. Since 10-year gilt yields are now over 2.1% (up from 0.7% in July 2021), such losses will be several multiples of our more narrowly defined estimate.

The market expects that the MPC will raise Bank rate to 1.25% at its June meeting. No one doubts that further increases will be needed. A major adjustment in global interest rates, long and short, is beginning to take shape. The lesson for the future is not that any one institution lacks foresight about inflation or future interest rates. It is rather that decisions about monetary policy and government debt management are at present reached by an opaque and dysfunctional amalgam of the deliberations of central banks and treasuries. Insufficient attention is paid to their fundamental interconnections. Managing a treacherous interest rate adjustment requires more effective arrangements.

Professor Jagjit S Chadha said:

“Our calculations illustrate the importance of management of government debt.  The QE programme has created a huge quantity of short-term liabilities which pay Bank rate and in a hiking cycle have left the Treasury with an enormous bill and heavy continuing exposure to interest rate risk.  It would have been much better to have reduced the scale of short-term liabilities earlier, as we have argued for some time, and to exploit the benefits of longer-term debt issuance.  This is very much a question for the Treasury to answer.”

Paper

Allen, W., Chadha, J., & Turner, P. (2021). Commentary: Quantitative Tightening: Protecting Monetary Policy From Fiscal Encroachment. National Institute Economic Review, 257, 1-8.

https://voxeu.org/content/quantitative-tightening-protecting-monetary-policy-fiscal-encroachment

[1] To be precise, this is an estimate of how much interest would have been saved by issuing a 2-year fixed rate bond for £600bn in July 2021, rather than borrowing £600bn at Bank rate from July 2021 until now, and issuing a fixed rate bond now for that amount maturing in July 2023.