Tough task: Reeves leaving a Cabinet meeting in London. She needs to raise as much as £35bil after higher borrowing costs and a weaker growth outlook wiped out a fiscal buffer she had earlier. — Bloomberg
London: Britain’s Chancellor of the Exchequer Rachel Reeves will need to find a further £4bil or about US$5.4bil to put her budget back on track if the Bank of England (BoE) decides to stop active gilt sales at a critical decision this week.
Alongside its interest-rate decision on Thursday, the central bank will announce how quickly it plans to unwind its crisis-era quantitative easing (QE) portfolio in the coming 12 months – with potentially painful consequences for Reeves ahead of her budget on Nov 26.
As the BoE is losing money on the holdings, a decision to scale back the pace of reduction would increase the costs to British taxpayers.
That would be a blow for Reeves, who already needs to raise as much as £35bil after higher borrowing costs, a weaker growth outlook and a series of policy U-turns wiped out her fiscal buffer.
The bank now faces an awkward trade-off between the fiscal cost of slowing gilt sales and the risk of further destabilising financial markets by continuing to ask investors to buy large amounts of bonds.
Yields on 30-year securities hit their highest since 1998 this month.
BNP Paribas SA expects gilt sales to be scrapped entirely to shield markets from “further adverse pressures”.
That would mean the BoE maintaining the portfolio at higher levels than would otherwise be the case.
The extra cost of indemnifying the BoE for its interest-rate losses would make it harder for Reeves to meet her main budget rule that taxes must cover day-to-day spending by the 2029 to 2030 fiscal year.
In March, the chancellor had £9.9bil to spare, but is now thought to be billions of pounds in deficit.
Under QE, the BoE bought £875bil of gilts between 2009 and 2021, plus £20bil of corporate bonds, to help the economy in the financial crisis, Brexit and Covid.
Quantitative tightening (QT) began in 2022, with the BoE reducing its holdings by £100bil a year through a combination of letting maturing bonds run off and actively selling debt. It is now £558bil.
The BoE is expected to announce it is slowing or stopping sales from October. Its own survey last month found that investors on average see the run-off rate being reduced to £72bil, implying £23 billion of sales.
That’s less than half the £51bil that will be sold if the central bank decides the maintain the current pace.
However, slowing QT runs the risk of breaching the BoE’s “value for money” requirement on “protecting public funds” set out by the chancellor.
Barclays Plc UK chief economist Jack Meaning calculated in May that scrapping active sales altogether would cost £4.3bil in the binding 2029 to 2030 financial year, equivalent to raising corporation tax by one percentage point or value added tax by half a percentage point.
Since then, changes in market prices “probably imply a worse impact”, he now says.
Some of that loss could be recouped if gilt yields were to fall in response to a BoE announcement on an end to active sales, but the yield effect is far less certain.
Meaning thinks the BoE will reduce QT to £75bil. BNP Paribas said its “base case” is that “the BOE will end active sales altogether”.
HSBC Holdings Plc and Nomura Holdings Inc expect the BoE to maintain a £100bil run-off rate but to skew sales to short-dated gilts to avoid disturbing the long-end where volatility has been sharpest.
The interplay between the bank and the Treasury caused by QT may damage the perception of BoE independence, according to Andrew Wishart, senior UK economist at Berenberg Bank.
“They will definitely be aware of the fiscal consequences. At the margin, that could move the dial a bit,” he said.
Governor Andrew Bailey has hinted at a change in the pace of unwinding, saying the decision will be “more interesting this year” as officials weigh up the impact of QT on government bond markets.
The bank is losing money on the portfolio in two ways.
Interest-rate losses come about because the BoE pays its benchmark rate, currently 4%, on the reserves created to buy the gilts but earns only 2% to 2.5% on the securities.
Separate valuation losses arise when gilts are sold, though these only affect Reeves’ secondary rule relating to debt.
Ending or reducing active sales would mean a larger gilt portfolio than the Office for Budget Responsibility forecast in March, resulting in a bigger interest bill projection in the key 2029 to 2030 fiscal year.
However, valuation losses require the government to issue tens of billions of pounds more gilts in order to cover the shortfall at the BoE, with the extra supply potentially impacting market borrowing costs.
The BoE has raised its estimate of how much QT lifts gilt yields over the past two years from less than 0.1 percentage point to between 0.15 to 0.25 percentage point.
A National Bureau of Economic Research paper last year by former BoE policymaker Kristin Forbes estimated the impact at up to 0.7 percentage points.
Between 2009 and early 2022, when rates were below 2%, the BoE made a £124bil profit on the QE portfolio, which the government spent.
It has since made £93bil of losses and is on track for a net lifetime loss of over £100bil. — Bloomberg
