Britain’s economy is set to bounce back as coronavirus restrictions ease in the weeks ahead. The question is whether the recovery will feel like the release of “a coiled spring,” as the Bank of England’s chief economist Andy Haldane believes, or something a little less explosive.
No one should presume to know the answer, but we should prepare for the possibility that spending is very strong, inflationary pressures intensify and official interest rates rise earlier than expected from the current low of 0.1 per cent. Those running banks would be wise to think this could well come with a large increase in effective taxation.
For the reasons why, you need to look at the BoE’s quantitative easing programme. It has doubled in size as a result of the pandemic and by the end of this year, the central bank will have created £895bn of money, almost entirely to buy government bonds. These funds have ended up in bank accounts, which commercial banks park overnight at the BoE earning the official interest rate.
QE therefore converts long-term government liabilities into overnight borrowing, lowering the cost of servicing public debt. That’s one of its benefits. A cost is that this shortening of the effective maturity of UK government debt has greatly increased its sensitivity to changes in BoE interest rates. With almost £900bn of QE, if the central bank raised rates 1 percentage point, the government’s annual interest bill would go up by almost £9bn.
Such a direct and large link between monetary policy and the public finances raises questions over the independence of monetary policy. Ministers might quietly put pressure on the central bank to keep rates low.
While it is a theoretical danger, much more likely is that the government simply questions the need to pay interest on bank reserves. BoE governor, Andrew Bailey, has recently scoffed at the suggestion. “We pay interest on reserves because that’s how we implement monetary policy,” he told a Resolution Foundation audience in March.
Old BoE hands have been explicit that in saying such things, Bailey protests too much. Giving evidence to the Lords’ economic affairs committee, former deputy governor Sir Paul Tucker said there was a strong chance the government would say, “for God’s sake, can you not stop paying interest on reserves?”
Charles Goodhart, a former BoE chief economist, told the committee that if interest rates rose, “it will become almost politically inevitable to return to paying zero interest on commercial bank deposits”. And Lord Adair Turner, former head of the Financial Services Authority, said in response to Goodhart’s evidence that logic suggested the BoE would end up paying interest on a small part of the reserves with a large tier remunerated at zero.
Bailey insists his former colleagues are wrong. Any suggestion of tiers of different interest rates would be fiscal policy and could not happen, he said. “That’s a tax, it’s a tax on the banking system and would be a tax on the economy,” he insisted.
The governor is, of course, correct; it would be a stealth tax on the banking system that would not show up on the government’s books. But that actually makes it much more likely than alternatives, such as an explicit tax on the banking system, an equivalent visible tax on households, or pressure on the BoE not to raise interest rates.
The BoE could hardly complain about different tiers of interest payments. It is already examining exactly this plan only in a slightly different guise to help banks if it were to set a negative interest rate. At no point has Bailey or anyone else from the BoE moaned that its own plan for tiers alongside negative rates is fiscal policy or an inappropriate subsidy to the banking system.
So, if I ran a UK bank, I’d look with some optimism at UK economic prospects and the possibility of higher interest rates. But I’d also expect opaque technical changes to reserve remuneration. In normal language, that would be a large stealth tax on banks.
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