Rethinking Debt Measures in Response to UK Fiscal Rules

The recent interest rate decision by the Bank of England has had a more substantial impact on the government’s fiscal posture than on the economic landscape itself.

Over the past year, I have highlighted the rising fiscal implications of monetary policy, with this month’s Bank meeting exemplifying that trend. The monetary policy committee opted to maintain interest rates at 5 percent, supported by an almost unanimous 8-1 vote. However, the more critical development for the government was the decision to continue the reduction of its balance sheet by an additional £100 billion over the next year, a continuation of the previous year’s pace.

This move towards “quantitative tightening” might produce unforeseen consequences for the fiscal leeway available to the new chancellor at her first budget presentation next month. It’s essential to unpack the mechanics of this process and its implications for government strategy.

The quantitative tightening undertaken by the Bank entails selling government bonds back to investors while also allowing certain bonds to mature without reinvesting those proceeds. This action stands in stark contrast to Quantitative Easing, where central banks accumulated vast amounts of government and corporate debt to stimulate the economy post-2008 financial crisis. In the UK, QE was activated following the Brexit referendum in 2016 and again during the pandemic in 2020.

The current contraction of the Bank’s balance sheet, which once surpassed £1 trillion, signals a departure from emergency economic conditions that previously demanded substantial central bank support. Notably, the Bank of England is the first major central bank globally to actively sell off assets rather than merely allowing them to reach maturity, a significant distinction from the US Federal Reserve, whose quantitative tightening has occurred without direct asset sales due to the shorter maturity of its bonds.

This brings about important fiscal ramifications. During the period of gilt purchases, interest rates were at historic lows, leading to inflated bond prices reflecting a strong demand for secure investments during uncertain periods. However, when the Bank began selling bonds in 2022, the value of gilts had fallen as high inflation diminished fixed coupon returns. Consequently, the Bank realized losses instead of delaying them. In 2023, estimated losses from the depreciation of bonds reached £21 billion. Additionally, the Bank incurs substantial costs by paying interest on the reserves created when it initiated QE, a point that has sparked discussions among political leaders.

These losses are compensated by the Treasury, which remits payments to the Bank quarterly, affecting the public debt measures that both Jeremy Hunt and Rachel Reeves pledged to reduce within five years.

This context underscores the significance of the recent Bank decision, which ostensibly should not affect the government since the pace of £100 billion in QT remains unchanged. However, the method of achieving this figure is pivotal. Over the coming year, a record amount of debt, totaling £87 billion, will mature, meaning the Bank will conduct bond sales totaling just £13 billion. This marks a decrease from the nearly £50 billion executed last year.

Reduced sales suggest a lesser immediate financial burden on the exchequer, potentially providing Reeves with additional fiscal flexibility for her upcoming budget.

The extent of this flexibility largely hinges on the Office for Budget Responsibility’s assessment of the Bank’s future QT strategy. Back in March, the OBR projected annual bond sales of £48 billion over the subsequent five years. Should the fiscal watchdog opt to apply the new figure of £13 billion across the five-year span, Reeves could effectively gain an additional £10 billion in fiscal space, per analyses from financial experts. Such extra funding could allow room to address winter fuel payments and revisit the contentious two-child benefit limit. Conversely, had the Bank executed higher sales than the announced £13 billion, it could have compelled Reeves into implementing more severe tax increases.

It is evident that the current scenario, in which technical decisions regarding the central bank’s balance sheet influence whether a chancellor can sustain benefits for vulnerable groups, is unsustainable.

One immediate avenue for Reeves to mitigate the adverse effects of the existing arrangement between the Bank and Treasury, while also rendering the fiscal rule more rational, is to adjust the debt measurement used in the fiscal regulation. Speculations are rising that Reeves and her team may resort to such a change, a move that could instantaneously yield an extra £20 billion in budgetary space.

This approach may raise eyebrows as a strategic adjustment by a new government facing challenges. However, the rationale is sound, especially given Labour’s reluctance to pursue alternative methods to mitigate the financial burden of monetary policy, like modifying the interest payment structure on reserves. Furthermore, the chancellor remains committed to achieving a reduced debt ratio by the fifth year of the OBR’s forecasts, with Labour showing no inclination to eliminate the current indemnity arrangement.

Consequently, amending the debt measure emerges as the most viable strategy to enhance the Bank’s autonomy from fiscal pressures and recalibrate the debt rule into a more sensible benchmark moving forward.