BOE balance sheet shrinkage (Part 2)

The Bank of England's fiscal indemnity is about to be triggered—big time!

• BOE is now making a loss on monetary income and will generate losses on APF sales given the recent gilt sell-off;

• These losses will trigger the BOE’s fabled indemnity, with a fiscal cost that will be considerable over the next few financial years (at least);

• UK institutional arrangements differ to the US—where the Fed uses future monetary income to offset todays losses over many years;

• In short: the indemnity is about to become a crucial part of the policy discussion, and will put more pressure on an already-under-fire Bank of England.

We previously noted—based on Bank of England balance sheet as of September last year—that the BOE indemnity from the Treasury would be triggered once Bank Rate moved above 115bps. Since then, policy has tightened significantly and Bank Rate reached 225bps last month—and is rising fast.

At that time we noted, “should Bank Rate reach 200bps… APF [Asset Purchase Facility] would deliver a loss over the course of the program of GBP100bn.”

Moreover: “If one possible outcome of the pandemic is a durable escape from the liquidity trap and shift to a regime of permanently higher average inflation and interest rates rates, then losses on the APF could be considerable indeed. In which case, the mysterious HM Treasury indemnity would indeed come into play—big time.”

Since then, the energy crisis has been folded onto the post-pandemic reflation and lingering effects of Brexit in the UK—causing inflation to exceed anything that could be imagined 12 months ago.

Monetary tightening is ongoing. And the fabled indemnity for the BOE balance sheet is about to be triggered, with important fiscal implications at a difficult time.

But how large might these losses be?

Bank of England “profitability”

There are in fact two sources of losses due to the BOE balance sheet that will have fiscal implications soon, neither of which were featured in the recent “mini-budget” —but will be worked into the Office for Budget Responsibility (OBR) forecast update in a few weeks.

First, there are “flow” losses. The BOE is now losing money on the asset purchase facility as the interest rate on bank reserves exceeds the coupon yield on the APF. The latter is roughly 200bps (we’ll come back to this shortly) whereas Bank Rate is currently 225bps and increasing.

The first chart below shows the cumulative coupons on APF holdings (left) as well as the face value loss plus cost of Bank Rate applied to reserves if held constant at 225bps. In short, the cumulative coupons of GBP238bn over the program are not enough to offset the face value loss of on gilt purchases of GBP112bn plus the loss on remuneration of reserves of GBP261bn over the program—with a total loss through 2070 of GBP135bn.

But this thought experiment is a little silly.

Over this horizon the Bank will eventually have to expand her balance sheet through ‘normal’ open market operations—to meet growing currency and reserve demand, possibly from around 2030 if not before, creating monetary income elsewhere in the form of higher coupon bonds.

Still, the decision to carve out the APF that was first taken in 2009, including through the fiscal indemnity, puts intense focus on these losses—including their fiscal implications—at a difficult time.

The second source of losses on “stocks” given the BOE’s intension to sell Gilts and accelerate the downward balance sheet adjustment.

The chart below shows the price of each gilt held within the APF portfolio (as of 3pm on Weds 28th Sept, not far from today) relative to both face value and the average purchase price. Obviously, the longer the maturity the larger the loss given the duration and yield curve repricing.

All APF bonds are below their average purchase price, most are also below par.

Now, the Bank intends to sell Gilts in roughly equal size from three maturity buckets: “defined as gilts with a residual maturity of 3-7 years (short), those with a residual maturity of 7-20 years (medium), and those with a residual maturity of over 20 years (long).”

To give a sense of how this will work, to offload GBP40bn in Gilts through asset sales roughly evenly across the portfolio, given market pricing, roughly speaking the Bank will have to sell GBP30bn in face value gilt holdings. They will then report losses to the Treasury GBP10bn that will require transfers from the government. Effectively this is a sterilisation operation. HM Treasury/DMO issuance will sterilise GBP10bn in reserves, or one-quarter of face value sales, in order to deliver on the Bank’s downward balance sheet adjustment.

If asset prices adjust down more, sterilisation will obviously increase.

And such sales bring forward APF losses from the future.

But should the fiscal accounts be burdened additionally at this time?

In any case, the optics will be very bad for the BOE.

What will be the fiscal impact?

The below chart offers three scenarios for Bank Rate against which losses through the fiscal indemnity can be judged.

These scenarios map into the below losses (by fiscal year).

Whereas with unchanged Bank Rate (at 225bps, Scenario 1) the fiscal indemnity would be called on at < GBP8bn per year over the next decade, losses increase sharply with further tightening.

If Bank Rate reaches 600bps in the year ahead (Scenario 3) losses will exceed GBP30bn per year over the next 2 years. In contrast, a more reasonable baseline with Bank Rate reaching 475bps (Scenario 2) losses reach about GBP20bn this year and next.

To this we should add up-front losses from outright asset sales. If such sales go ahead, this will add about GBP10bn in additional losses per year for every GBP40bn in balance sheet contraction. (This analysis ignores corporate bond sales and associated losses.)

Indemnity in context

To put this indemnity in context, the abolition in the top rate of tax (of 45p) was projected to have an impact of about GBP2bn per year in the steady state. The BOE indemnity will be GBP20-30bn per year for the next two years and potentially much more later.

The primary deficit from the March 2022 OBR forecast was projected for 2022/23 at GBP27bn and for 2023/24 at GBP13bn.

Until now, including at the March 2022 forecast, the OBR reduced general government interest payments due to APF holdings. At the forthcoming forecast round they will have to revise up such interest payments due to the indemnity for the first time. These upward revisions over the next 2 financial years are reasonably equal to, or larger than, the previous primary deficits forecast for these two years.

Alternatively, the indemnity could come in slightly below, but close to, the cost of the mini-budget (ex-45p tax measure) of GBP27bn in 2022/23 and GBP31bn in 2023/24.

Does the indemnity make sense?

This brings UK-specific institutional arrangements into focus.

The problem with the indemnity, compared with arrangements in the United States for example, is that it creates an additional financing need for HM Treasury at exactly the time that net issuance is increasing for other reasons—due to (necessary support during) the energy crisis as well as the (unnecessary) mini-budget giveaways.

When these losses are realized, it will increase pressure on the Bank of England from politicians and the popular press claiming that they are adding to the burden on taxpayers at a difficult time—making future QE, of needed, more difficult to initiate as a consequence.

And at a time when Bank leadership is coming under pressure for other reasons—inflation overshooting and pension industry liquidity management—such losses will be awkward to explain.

In contrast, in the United States equivalent losses will be recorded as deferred assets and run down over many years from Federal Reserve monetary income, lowering transfers to the US Treasury in the future but not burdening net issuance today.

Contrast this with the UK indemnity, which requires explicit transfers at this time—during a brewing fiscal crisis!

Of course, it is difficult to unwind these institutional arrangements right now. To do so would bring accusations of fiscal dominance and fears about the encroachment on the BOE independence.

So it is likely that these arrangements will have to be adjusted in other ways—such as through a tax on banks’ income on reserves.

Regardless, there are important fiscal implications of the BOE indemnity in the next few years. We will have to get used to that fact—beginning with the OBR fiscal update in a couple of weeks.

The content in this piece is partly based on proprietary analysis that Exante Data does for institutional clients as part of its full macro strategy and flow analytics services. The content offered here differs significantly from Exante Data’s full service and is less technical as it aims to provide a more medium-term policy relevant perspective.

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