We are now facing a rising cost of living crisis as the UK recovers from the economic fallout of the pandemic. Underpinning the crisis is a changing set of macroeconomic dynamics, giving policymakers a new set of factors that could slow economic growth. After a decade of dangerously low inflation, interest rates from zero to the floor and nearly £1 trillion in quantitative easing (QE), inflation has risen to a 40-year high and is set to rise further. Traditionally, higher inflation would prompt the Bank of England (the Bank) to raise interest rates to change credit conditions and dampen aggregate demand. But policymakers face a huge problem — the central bank’s monetary policy toolkit is outdated and not designed to deal with today’s changing macroeconomic environment. So while many households across the UK are struggling with the cost of living soaring, changes in interest rates mean banks will increase their profits through billions of pounds worth of payments (income transfers).
A harmless change to the Bank’s monetary policy framework in 2009 now means that commercial banks are paid for all central bank currency they hold at the Bank’s policy rate. But paying interest to the banking industry for holding money in this way is the exception, not the historical norm. Given the lack of policy alternatives at the time, this approach to monetary policy may have been a stopgap in 2009. But with the banking industry currently holding nearly £1 trillion in central bank reserves, higher inflation and rising interest rates, these three traditionally distinct issues are needlessly conflated, and governments are paying an unnecessarily expensive price . Bank rate adjustments aimed at changing credit conditions are now having a huge impact, increasing the amount of interest paid by the government and the profitability of the banking sector.
The impact of higher interest rates on government spending is well documented. In his most recent spring 2022 statement, Chancellor Rishi Sunak warned that a further 1% increase in inflation and interest rates could increase the government’s debt interest payments by £18.6bn in 2024 – £25 and £2. 21.1 billion by the end of the forecast. These increased costs could threaten – at least politically, if not economically – governments’ attempts to further stimulate the economy amid a slowing recovery and the transition to net-zero emissions.
At the same time, there has been far less focus on how interest rate changes will significantly boost banking profits at the cost of governments. Given that the Bank controls interest rates by paying money to the banking industry, raising interest rates will result in a substantial revenue transfer from the Bank to the banks, thereby significantly increasing their potential profit margins. Looking at the different potential ranges of interest rate paths, an average rate of 0.75% to 3% could mean between £6.9bn and £27.62bn in revenue transferred from the BoE to banks, even if the BoE plans to unwind QE March 2023 . In the Office for Budget Responsibility (OBR) five-year forecast range, an interest rate of 0.75% to 4% would mean a cumulative £30.34 billion to £161.8 billion for the banking sector.
To more accurately estimate the Bank’s revenue transfers to the banking sector, we cross-referenced market expectations for interest rates with reserve stocks consistent with the Bank’s current cancellation of quantitative easing programs. Markets expect rates to rise to 2.5% by the summer of 2023, before gradually falling to 2.0% in January 2025. Under this implied interest rate path, the Bank of England will transfer £15.08 billion to the banking sector by FY22 – 23 – equivalent to reversing all cuts to welfare payments since 2010 – a total of cuts by FY2024 £57.03 billion – £25 – is enough to overhaul more than 19 million homes in the UK, or send a £2,000 cheque to every household in the UK.
Given the current financial situation, there is good reason to believe that these revenue transfers are likely to be passed directly to the bank’s bottom-line profits, rather than being paid to customers who hold deposits in the bank. At a time when many households in the UK are struggling with rising living costs, these income transfers will not only boost profits for banks, but they will also go to the already heavily subsidised banking sector, which saw pay rises even more sharply last year That’s three times the rate of wage growth in the rest of the UK economy. Income transfers will not carry additional credit risk and, arguably, provide additional services; they arise from the banking sector’s exclusive ability to hold central bank reserves.
While many organisations, such as the OBR and the Ministry of Finance, may often refer to central bank reserves as a form of public debt, we show that they are not debt instruments (i.e. lending by banks to banks). Instead, they are a form of government currency, such as banknotes and coins. There is no borrowing or repayment, so the bank does not pay any interest. Paying interest and thus making large transfers to the banking sector is just one of many policy options available to governments.
One possibility to avoid such a sizable income transfer to the banks is for them to quickly sell off their current bond holdings built up through their massive quantitative easing programs, which would significantly reduce the amount of central bank reserves held by the banking sector. In addition to jeopardizing monetary and financial stability, this would significantly increase the government’s net interest servicing costs and result in significant losses for banks that must be covered by the Treasury. Given that banks buy most government bonds when interest rates are low, selling them when interest rates are high means banks will get less than what they paid for. These losses could be between £105bn and £265bn.[v] A quick sale of government bonds by banks would also substantially raise interest rates, while reducing the government’s profits from the government bonds held by banks, thereby greatly increasing the government’s net debt servicing costs.
Under the existing monetary policy framework, the central bank is in a dilemma: either continue to transfer large amounts of revenue to the banking sector, or substantially increase the government’s debt and interest servicing costs. The Bank’s monetary policy framework is too expensive, politically elusive, and leads the Bank to divert finances to one specific sector of the economy (other sectors are not involved).
There is a policy alternative and precedent called ‘Tiered Reserves”, used in other countries (in the Eurozone, Japan and formerly in the UK). This allows a clear separation of the bank’s policy rate from the government’s cost of servicing interest and the profitability of the banking sector. Importantly, the tiered reserve system Meaning banks don’t have to unwind quantitative easing or sell any government bonds at the expense of taxpayers and monetary and financial stability.
Based on the experience of the Bank of Japan (BoJ) and the European Central Bank (ECB), we offer an illustrative suggestion – three different possibilities for paying central bank reserves – how such a framework could work in the UK. Based on market expectations for interest rates, a tiered reserve system could save the government between £10bn and £15bn in revenue transfers to the banking sector by March 2023, and by March 2025, even if quantitative easing is cancelled £25bn to £57bn.
Transitioning to such a framework will require important policy decisions that should not be taken lightly. The Ministry of Finance and the central bank criticized the proposed reform as a backdoor fiscal policy, given that the tiered reserve system would significantly reduce the government’s interest costs. However, these condemnations ignore the alternative – transferring billions of pounds of revenue to the banking sector during the cost of living crisis – as a form of fiscal policy that is certainly not aligned with the public and social interests.
Another consideration is that taking these major revenue shifts from banks will impact their profit margins, which could lead them to pass losses on to customers by raising borrowing costs. However, the problem only arises when banks typically need to raise interest rates and push up the cost of credit.As noted in a recent IMF (2022) paper, which advocates this tiered reserve system, passing higher borrowing costs to clients “would be a feature, not a bug, as it would amplify the desired contractionary effect”. Transitions and trade-offs need to be carefully managed, but given that raising interest rates and raising borrowing costs is exactly what the Bank is trying to do, the problem is not insurmountable .
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