For over a dozen years, central banks across the developed world have been operating quantitative easing. During nearly all that time, interest rates were very low and those who asked questions about what would happen to this vast stock of assets on the public sector balance sheet when interest rates returned to more normal levels were in a small minority.
Now that interest rates are rising, we are learning the answer. The numbers do not make for comfortable reading for central banks or finance ministries. In the UK, for example, one estimate is that the Treasury may need to provide over £130bn to the Bank of England over the next six or so years to keep its balance sheet whole.
To understand this figure and how it affects the Bank, it is necessary to understand the Bank’s balance sheet and how the purchases of gilts and other assets have been managed under QE.
Although QE was only introduced about a dozen years ago, the Bank has always bought and sold assets as an integral part of its interaction with markets, an activity that goes under the name open market operations. Classic OMOs are a tool of day-to-day market, rather than long term economic, management. As such, they are usually fairly small and of short tenure – traditionally they have been conducted through the Bank’s own balance sheet.
But when the Bank first contemplated QE operations in 2009, it realised that they could grow to be very large and outstanding for a long time. As a result, it felt the need to separate these asset purchases from more traditional OMOs. It decided to conduct them through a new facility, the asset purchase facility, a special purpose vehicle operated by a new wholly owned subsidiary of the Bank, the Bank of England Asset Purchase Facility Fund. This was not only to stop them complicating the operation of the rest of the Bank’s balance sheet, but also because it made it easier to identify the profits and losses arising from QE. This was necessary because right from the start the Bank secured an agreement with the Treasury that these profits and losses would be for the Treasury’s account – in other words, the Treasury would take any profits and bear any losses.
The mechanics of the asset purchases were then relatively straightforward. The Bank lent money to BEAPFF, which bought the assets from the market. BEAPFF thus had a simple balance sheet which was long the assets bought in the market, financed by a loan from the Bank. And crucially BEAPFF also had a guarantee from the Treasury that it would keep this balance sheet whole – a non-tangible but far from negligible asset. So, the BEAPFF was square.
The effect on the Bank’s balance sheet was almost as simple. It had an asset, the loan to BEAPFF, and in practice a matching liability in the form of bankers’ balances, the reserves left by the commercial banks. Both asset and liability were interest bearing at the Bank’s lending rate and the Bank’s position was, therefore, also square.
Thus, the Bank had successfully isolated its own balance sheet from the consequences of QE and the resulting financial performance of BEAPFF. The Bank (aware perhaps of its unusually low capital base compared to its peers) is almost alone among central banks in having agreed this position with the Treasury: most central banks have not tied their finance ministries into their QE operations in this way and many face considerable direct losses.
For the first decade of QE, the operation was very profitable for BEAPFF and the Treasury. Using a loan at 0.1% to buy gilts yielding closer to 2% produced large profits. Over the decade, BEAPFF transferred around £120bn to the Treasury, where it was both very welcome and entirely unremarked upon. No chancellor of the exchequer felt the need to draw attention to this revenue stream.
But times have changed. With the rise in interest rates from 0.1% to 3%, BEAPFF’s financial position is looking much less healthy. As interest rates have risen, BEAPFF’s finances have suffered in two ways: on the asset side, the bonds it has bought for the APF have fallen in value, and on the liability side, the cost of servicing the loan from the Bank has risen sharply. The net result is a twofold hit: on a mark-to-market basis its balance sheet shows a large deficit and its profit and loss account shows a running loss as the income from the assets is not enough to pay the interest due to the Bank in servicing the loan.
It is the combination of these that leads to the calculations that the Treasury may need to find as much as £130bn over the rest of the 2020s to keep BEAPFF solvent and remove any knock-on effect from impacting the Bank.
It does not matter that for the first dozen years of QE the operation was very profitable for the authorities. BEAPFF has transferred about £120bn to the Treasury in profits since 2010, thus making their calls on it now more a matter of timing of flows in and out than any wholly new money. Nor does it matter that in other countries, central banks and their finance ministries are facing even more serious problems and have handled the matter less adeptly than the UK. Such arguments are entirely valid in economics and entirely without traction in the febrile world of politics.
Instead, all the public will focus on is the headline figure: the need to transfer £130bn or so to a subsidiary of the Bank to compensate it for the consequences of its own interest rate policy. At a time when he is pursuing unpopular austerity policies and struggling to keep both the country and his parliamentary colleagues onside, Jeremy Hunt, the chancellor, may well rue the timing of this news.
John Nugée, a former Chief Manager of Reserves at the Bank of England, is Senior Adviser to OMFIF.