Logic tells us to change debt measure that affects UK fiscal rule

It’s a sign of our strange times that the Bank of England’s latest interest rate decision was more significant for the government’s fiscal position than it was for the economy.
I’ve written many times over the past year about the escalating fiscal cost of monetary policy and this month’s Bank meeting was a good example of the phenomenon. As expected, the monetary policy committee kept interest rates unchanged at 5 per cent this month, with a near unanimous 8-1 vote. But it was the second decision that was more important for the government, as the MPC said it would continue reducing the size of its balance sheet by another £100 billion in the coming 12 months, matching the pace of the past year.
This decision on “quantitative tightening” may end up having unexpected effects on how much fiscal headroom the new chancellor has at her maiden budget next month. It’s worth breaking down how it works and what the government can do about it.
The Bank’s QT process involves selling bonds on its balance sheet back to investors and also allowing bonds to mature without reinvesting the proceeds into similar assets. In this sense, QT is the reverse of Quantitative Easing, when the Bank and other authorities hoovered up swathes of government and corporate debt to revive the global economy after the financial crisis in 2008. In the UK, QE was also turned on after the Brexit vote in 2016 and with the onset of the pandemic in 2020.
Shrinking the balance sheet, which at one point exceeded £1 trillion, is a sign that the world economy is no longer in emergency deflationary times that require huge doses of central bank stimulus. Crucially, the Bank also became the first major authority in the world that was forced to sell back assets — rather than just allowing them to mature and roll off the balance sheet — as the average maturity of the Bank’s gilts is around 15-20 years. In contrast, the US Federal Reserve’s QT has been happening “passively” without any sales, due to the short-maturity of its bonds.
It’s here that the fiscal consequences kick in. When the Bank was buying gilts, interest rates were at rock bottom and bond prices were high, reflecting demand for “safe assets” in uncertain times. But when it came to selling the bonds in 2022, gilts had fallen in price as high inflation ate into fixed coupons and higher interest rates generated far juicier returns on newly issued debt. When selling back bonds, the Bank was crystallising losses, rather than deferring them. In 2023, the losses from the falling value of bonds were £21 billion. The Bank also makes tens of billions in losses by paying out interest on the reserves it created when it started QE, a subject that has led Nigel Farage and Gordon Brown to ask for a rethink.
The losses are covered by the Treasury, which sends tranches of cash to the Bank every quarter — a flow that has a bearing on the measure of public debt that both Jeremy Hunt and now Rachel Reeves committed to reducing over a five-year period.
All of this brings us back to the Bank’s latest decision, which on the face of it should make no difference to the government as the £100 billion pace of QT was unchanged. This, however, hides how the £100 billion will be achieved. In the next 12 months, there will be a historically high amount of maturing debt, worth £87 billion, meaning the Bank is only going to carry out bond sales worth £13 billion. That’s down from the near £50 billion of last year.
Fewer active sales means a lower immediate loss for the exchequer to cover, and in theory, this should give Reeves some additional breathing room on October 30.
Whether or not this is the case will depend largely on what the Office for Budget Responsibility thinks about the Bank’s future QT plans. In March, the OBR assumed the Bank would be carrying out £48 billion of bond sales every year over the next five years. If the fiscal watchdog decides to take the new £13 billion and extrapolate it over the next five years, Reeves has magicked herself an extra £10 billion in headroom, according to number crunching from Goldman Sachs. That would be enough to reverse the decision to limit winter fuel payments and loosen the controversial two-child benefit cap. Conversely, had the Bank done more than the announced £13 billion, it might have forced Reeves into more desperate tax rises.
Needless to say, the current situation, where technical decisions about the size of the central bank’s balance sheet can be the difference between whether a chancellor cancels benefits for pensioners or not, is untenable.
One immediate way Reeves can limit the perverse impact of the UK’s current arrangement between the Bank and Treasury and make the fiscal rule less farcical is to change the debt measure that is the subject of the fiscal rule. There is growing speculation that Reeves and her team will be forced to do exactly this — a decision that will also give her a temporary but significant £20 billion in headroom at a swipe.
Many will see this as a cynical moving of the goal posts by a new government stuck in a bind. But the logic is compelling, particularly as Labour has ruled out other important ways of reducing the cost of monetary policy, such as changing the system of paying full interest on reserves. The chancellor is also wedded to her target to reduce the debt ratio in year five of the OBR’s forecast, and Labour has made no noises about scrapping the indemnity arrangement.
This all leaves a debt measure change as the best way to strengthen the Bank’s independence from fiscal considerations and make the debt rule a slightly more sensible target going forward.