Following the 2008 financial crisis, the Bank of England undertook quantitative easing and resumed it as a response to the Covid-19 lockdown. By early 2022, the Bank had bought £875bn of UK government bonds and £20bn of commercial bonds. However, recent reductions in the balance sheet have now trimmed the government bond portfolio down to £693bn. It is now time to consider how these losses and the drain on the exchequer can be mitigated.
Between 2009 and 2022, the Bank sent £124bn in bond profits to the Treasury, thanks to earning more on bonds than it paid on commercial bank reserves. Now, with the sharp rise in interest rates over the past two years and bond sales at a loss, the Bank is facing major losses, which taxpayers will have to pay for as they are incurred under an indemnity between the Treasury and the Bank. It’s becoming ever more crucial to explore ways to mitigate these losses, perhaps by emulating some of the European Central Bank’s strategies.
Inflation in the UK started to accelerate in 2021, tripling the target rate by the time of the Russian invasion of Ukraine in February 2022 and peaking at 11.1% by November 2022. The Bank ascribed the rise in inflation to the energy and food price rises brought on by the invasion of Ukraine. This does not explain why Switzerland, Japan and China kept inflation rates to around 2% over the war crisis despite being large importers of food and energy, nor why UK inflation was so high before the war.
In February 2022, the Bank of England announced the sale of its £20bn commercial bond portfolio. In September, the Bank aimed to slash bond exposure, proposing to sell £80bn of gilts in the first year. The move, combined with hiking the base rate and Liz Truss government’s ‘mini-budget’ of increased spending and tax cuts, further depressed the bond market. This then suffered a further sharp sell-off thanks to the overgeared bond positions of some pension funds in bonds centred on those invested in liability-driven investment funds.
In response, the Bank temporarily reversed its quantitative tightening, switching to a further burst of bond buying. It added another £19.3bn of gilts or 0.9% of gross domestic product, which stabilised the market and drove long yields back down. It was subsequently unwound.
Borrowing ECB strategies
It is worth examining the practices of the ECB in this context and its shareholder central banks in the Eurosystem, which carry out the lion’s share of the ECB’s market operations. Some Eurosystem central banks, such as Deutsche Bundesbank and De Nederlandsche Bank, are making running losses. The Eurosystem mitigates further losses by holding bonds to maturity rather than selling them. At maturity, the bond repays at the original issue price, well above the market price of the longer bonds they own today.
The ECB sets a minimum reserve requirement of 1% of liabilities for commercial banks with no interest paid. The Bundesbank has discontinued interest payments on government deposits. The ECB sets a lower deposit rate of 3.75% than the 4.5% it charges for borrowings by commercial banks and others. These features reduce running losses. By contrast, the Bank of England maintains the same interest rates – currently 5.25% – on both commercial bank deposits and loans, paying the full amount on all reserves and maximising the losses.
Compared with both the Federal Reserve System and the ECB, the BoE has been pursuing the most extreme policy by combining a run-down through maturing bonds with market sales. Where it sells long bonds, it takes large losses, as long bonds fall more when interest rates rise. As a result of its loss maximisation, the Bank so far has received payments of £74bn to cover losses. An estimated further £110bn is due by 2030, according to the Bank.
Urgent revisions needed in the UK system
While advisers at the Bank acknowledge they do not know how much the commercial banking sector needs by way of reserves, they believe it is less than today so they wish to shrink the number. They argue that long bonds will lose money regardless of whether they are held or sold now, assuming high rates persist. The decision makes the current fiscal situation far worse for the Treasury as they take a sure big loss now over a series of annual smaller losses in the future. The Bank argues that there is no great monetary purpose to the policy, emphasising that setting the base rate is the key policy to regulate inflation and economic activity.
As the only major central bank taking large losses on sales of long bonds and getting taxpayer compensation, urgent change is needed within the Bank of England. Since the government mainly looks at the government deficit excluding the Bank, UK Treasury payments to the Bank have a big impact on fiscal policy – which is meant to be the preserve of government only.
Adopting methods from the euro area could help the Bank in several ways. First, to reduce the losses. Second, to slow the impact of balance sheet reduction by varying rates of interest between lending and borrowing and third, to set minimum reserves that receive no interest.
Implementing such changes may require some revisions in the UK system and government recognition of the Bank’s need for future profit streams like other central banks. However, the Bank should cease selling long bonds in the market landing taxpayers with immediate large losses. Instead, they should concentrate on managing far more effectively the Bank’s huge stock of bonds as they run down to maturity.
John Redwood is Chief Global Strategist at Charles Stanley. He was Member of Parliament for Wokingham (1987-2024), and is an analyst, commentator on economics and author.
These are his personal views and not those of the company.
