Will the Bank of England’s quantitative tightening torpedo Reeves’ fiscal rules?
Rachel Reeves is in a pickle. At under £10bn, the Chancellor’s self-imposed fiscal headroom – the Treasury’s wiggle room within its fiscal rules – is already wafer-thin by historic standards. And it is under intense strain, given a recent slew of billion-pound government spending pledges such as reversing winter fuel payments cuts and scrapping the two-child benefit cap. Analysts are already predicting tax hikes of over £10bn come the Autumn budget, just to keep the chancellor on target.
Economists in the UK and beyond have admonished Rachel Reeves for the damaging effects of her precarious fiscal rules. Last month, Britain’s oldest independent economics research group, the National Institute of Economic and Social Research, warned the Treasury’s “narrow” fiscal headroom was doing more harm to UK business confidence than uncertainty in global trade sparked by Donald Trump’s tariff tirade, blasting the government’s “arbitrary fiscal rules” that “have served the country poorly.”
Last week, the IMF warned that “vulnerabilities have arisen” in the gilt market and urged the government to “stay the course and deliver the planned deficit reduction” because market shocks could “make it harder to meet the fiscal rules, given limited headroom.” And this week it was the turn of the OECD, which urged the Treasury to “step up” efforts to bolster its “very thin” fiscal buffers, expressing concern that it could cause “significant downside risk” to the UK economy.
Even if Reeves convinces economists that she can keep her rules intact, there remains one major area of spending she can’t control: quantitative tightening. This is the process of the Bank of England selling government debt back into the market, unwinding its quantitative easing (QE) programme from previous years. Quantitative tightening, or QT, has become a major cost to the government because of the Treasury’s relationship to the Bank – and Reeves’ fiscal rules.
Quantitative tightening
Under a deal struck when QE began in 2009, the Bank of England hands the Treasury any profits it makes from managing its gilt portfolio, and the Treasury foots the bill for any losses.
The losses on interest – measured as the difference between the Bank’s interest rate and the interest it makes on the gilts – have surged in the wake of higher Bank rates, and are counted as part of day-to-day spending under Reeves’ fiscal rules.
These losses have become an eye-watering expense for the government. According to (very rough) projections by the Office for Budget Responsibility, the Treasury can expect a bill of as much as £50bn by the end of the parliament. But quite how big that bill is, and when it falls due, will depend on how quickly the Bank moves on QT.
Reeves is praying the Bank acts fast. The quicker it sells off the bonds, the smaller the interest loss on remaining debt, and the more her fiscal headroom grows.
But jitters in the gilt market could spoil the party. Analysts fear there is not enough investor appetite to absorb a high supply of government debt, and predict the Bank’s sales will slow.
If the Bank scraps active sales altogether, that could mean a whopping £5.9bn hit to the chancellor’s spending come the Autumn budget, analysts at Barclays predict.
A QT solution
But there is a way out for Reeves: She could rewrite the terms of her deal with the Bank. Some economists have called for the Treasury not to pay the interest losses and assume they will be offset by future gains. The Treasury’s relationship to the bank would be treated like a current account – going into overdraft when there are gilt interest losses but heading back into the black when there are profits.
The accounting trick would be a huge boon for Reeves – it would remove the uncertainty over the size of payments to the Bank, and free up tens of billions to bolster her fiscal headroom.
It would also bring the UK into line with the policy of many other central banks, including the Federal Reserve in the US. But will the bond market swallow the switch – or get spooked?
“We know the market is always jittery, the market will always be conservative,” said Nuwan Goonetilleke, head of capital markets at Phoenix Group.
“No one’s looking for any huge changes but the IMF statement was helpful in trying to create some wiggle room.
“Markets can work through these kinds of challenges, but against the [fiscal] backdrop is it just a magic trick or is it genuinely something they can get behind?
“If it [just] came [out] as “we’re going to implement it” would that spook the market? I’d say very much so [but] it would depend on the dialogue and the yardstick for measurement and how this progresses through the forecasts.”
But Simon French, Chief Economist and head of research at Panmure Liberum, told City PM there was “absolutely” merit in considering the move.
“The accounting approach is a better way of doing it because you’re not saying we’re going to avoid those losses, we’re just going to make sure they are recouped against Bank of England profits going forward,” he said.
“I think gilt markets would receive that pretty positively, because it shows a pragmatism without changing the issuance, the divestment or the reinvestment profile at all, so there’s nothing of substance for the gilt market to absorb.
“[But] there would be a suggestion that there’s a bit of an asymmetry – that you’re happy to take the profits on the way up but dilute the losses on the way down.”
French said changes to the recognition of QT interest losses should be open for consideration by the Treasury ahead of the Autumn budget. “You’d be disappointed if an options analysis that included that wasn’t presented to the chancellor,” he said.
But is the government amenable to the move? The Treasury did not respond to a request for comment.