Managing the fiscal risk of higher interest rates
The coronavirus pandemic has led to a large increase in the U.K.’s government debt, and the Office for Budget Responsibility has warned that a rise in interest rates might imperil debt sustainability. If the Bank of England Monetary Policy Committee were obliged to raise short-term interest rates to meet the inflation target, the interest costs of the commercial banks’ very large reserve balances, which the Treasury has guaranteed, would increase immediately, and the government might be pressed to reduce the primary deficit quickly. This note proposes a large compulsory swap of banks’ reserve balances for short and medium-dated fixed-rate gilt-edged securities. If the proposal were adopted, the government would have more time to make fiscal adjustments in the event of a rise in interest rates.