It was not covered or discussed much in Europe. The European Central Bank announced that it would stop paying interest on the minimum reserve balances from next month. This announcement was snuck in under the more important the rise in interest rates.
It is also a question of whether, after the ECB’s example, the Bank of England will follow suit.
Both Andrew Bailey, the Bank’s Governor, and Huw Pill the Bank Chief Economist have stated in the past that they are not fans; there are no plans for the future. The Bank’s chief economist, Huw Pill, and Governor Andrew Bailey have both said in the past that they are not fans of the idea. There are no plans to implement it.
The world has changed since then. For the UK government that is now paying the Bank to cover the losses from quantitative easing (QE), the temptation to choose the ECB option must be almost overwhelming.
Let’s begin with the basics and explain what central bank reserves are.
They are basically cash balances or deposits held by the commercial banks at the central bank. Before the financial crisis they were small and considered to be of little importance.
They reached unprecedented heights with the introduction of QE in the early 1990s – at last count, around PS840bn was allocated to the Bank of England.
The media has euphemistically called this central bank “money-printing”. The central bank will then determine the rate of interest for these deposits.
It was good news for the governments, as long as the official interest rates fell. What would have normally been a high interest rate on the government bonds being purchased, would be replaced with the official rate of interest, which was close to zero in the US and Europe.
This resulted in a significant saving for the government on its debt service costs.
Then. The process of reducing inflation by increasing official interest rates has been reversed.
The UK Treasury has already paid the Bank approximately £15bn as indemnity for losses on QE, when the Bank began asset purchases nearly 15 years ago. Bank estimates that taxpayers could be liable for more than £100bn in indemnified losses. It is clear that this burden would be eased if the Bank, following the ECB, stopped paying interest on some of its reserves.
In Britain, unlike the Eurozone, commercial banks do not have to meet a formal minimum reserve requirement, although there used to be a voluntary target.
As a precaution against a liquidity shortfall, banks must still hold at least a portion of their liabilities in central bank reserves.
Since the US bank runs, these risks have risen significantly. Reserves are therefore likely to stay high even though the Bank is now trying to reverse its QE.
According to estimates circulating around the City, if the Treasury followed the ECB in following its minimum reserve requirements, it would save about PS1bn a yearly in interest payments.
It’s not enough to finance the tax cuts that Downing Street may be hoping to announce before next year’s elections, but it helps. The sums could be even higher if the Bank stopped paying the interest on a larger proportion of reserves.
However, there are some obvious disadvantages. The most obvious is that this could be seen as a type of default by the government.
I am surprised that it hasn’t caused more controversy in Europe. Paying nothing on reserves when the official rate of 4.25pc is a tax to the banks and therefore is more of a monetary than fiscal decision, which would normally require direct approval from the politicians.
The ECB, as is its style, has tried to portray the initiative as a simple way to improve the efficiency of monetary transmission. Tosh. The ECB’s purpose would be better served if they stopped pretending.
Raising interest rates has the primary purpose of reducing demand by tightening credit. It is difficult to see how paying nothing for reserves will improve this function. It would actually have the opposite impact by deterring people from holding cash in reserves.
The reason that most governments in the eurozone don’t care is because the ECB could help them avoid the embarrassment and cost of having to recapitalise central banks.
In the Eurozone, unlike Britain, losses incurred by QE were not covered by a generalised indemnity. In some cases, these losses eat away at capital and threaten solvency. By not paying interest on reserve funds, taxpayer bailouts can be delayed.
In the UK, things are a bit different because of indemnity. The Bank of England does not face bankruptcy, but the Treasury is paying for the losses from QE. As a result, the Government’s debt service burden has risen alarmingly, which reduces the ability to spend on other things.
Payment of interest on bank reserves is a transfer by the government to the banks. This limits the room for maneuvering under the fiscal rules and could force the Chancellor to tighten fiscal policy in an economy that already struggles to grow.
It’s possible that the Office for Budget Responsibilty could ignore these transfers when assessing if the Government is meeting its fiscal rules. But this is a separate issue.
The payment of interest on reserves artificially increased by QE feeds the notion that commercial banks are making excessive profits at a time where everyone else is struggling. Due to what is perceived as a monetary quirk by some, the banks appear to be making money at everyone’s expense.
As an alternative to canceling interest on reserves, the government of Giorgia meloni in Italy has imposed a direct windfall profit tax on banks. She is essentially taking two bites of the same cherry. A healthy economy needs a profitable and healthy banking system. Both approaches are unlikely to produce it.
This is highly technical material, but it’s not of great importance in the real world. The transfer of money from Treasury to Bank of England is a simple reshuffle of resources.
It is important to remember that perception is everything. If the government is accused of using financial engineering techniques to improve its fiscal situation, this would be a bad thing.
The Bank of England shouldn’t follow the ECB in this regard.