If you ask any of my colleagues, I certainly do like one or two cold pints - Leeds does carry a reputation for casual (and social) alcohol overindulgence - naturally, I’ve embraced the tradition.

But after a totally coincidental new office in Leeds and recent news coverage on the Bank’s supposed Quantitative Tightening (QT) ‘losses,’ it seems like casual overindulgence has been embraced by the Bank’s culture too. Perhaps financial strain warrants one or two pints as a reward for bank staff. Put short, the Treasury has been quoted quite a big bill for the Bank’s QT operations. 

Hell, ‘big’ might not do it enough justice. They are really quite massive. The Bank’s Asset Purchase Facility (APF) cites a figure anywhere between £45 billion and £85 billion, with some estimates going up to £230 billion; that’s quite an expensive dinner date.

Why is this keeping me up at night? Earlier this year, I wrote an article on QT with a clever pun (as you can see I’ve decided to continue the theme) where I claimed that QT does not create any ‘losses’ on its own and that instead, the cost to the Treasury is down to higher interest payments thanks to a higher bank rate. Such a statement seems antithetical to the costs that I’ve just cited, so it’s time for me to jump into the monetary policy crucible to cover my backside. 

To do this, I first must explain how QT actually works, which is something that I did not do very well in my last article. Partly, this is because I had to explain how both QE and money creation work - and these are both quite complicated - so if you need a refresher (which I would recommend before looking at QT), please have a look (and do come back!). 

Now, let’s try to understand why the Treasury is paying for dinner all of a sudden. The Bank-Treasury-QT love triangle is, in fact, a complicated square involving the Asset Purchase Facility (APF), a separate legal entity responsible for handling all of the Bank’s  QT and QE operations. When the Bank wants to engage in QE, the APF pays for bonds using a bank-rate-bearing loan from the BoE and then holds the bonds. The APF makes a profit if the returns on its gilt holdings (from coupon payments and any price change) exceed the cost of borrowing from the Bank (at the bank rate) and returns this profit to the Treasury. It makes a loss if the opposite is the case where the Treasury sends funds to the APF to repay the Bank loan. The FT provide a rather nice chart on how this all works:

Between 2009 and 2022, when the bank rate was lower than the average interest rate paid on gilt holdings, QE generated quite a hefty profit which was transferred to the Treasury, of a cumulative £124 billion. As bank rates have risen and gilt prices have fallen, the opposite has been the case since 2022: losses amounting to around £50bn.

Crucially, this ‘profit’ does not lead to an improvement in the government’s fiscal position as the bond interest and coupon payments come from the Treasury itself. Effectively, the APF profit is just the APF returning Treasury payments back to the Treasury.

Conversely, the APF sees a loss when the interest on the bank-rate loan is higher than that of the bond repayments. This is called APF ‘interest’ loss and is associated with ‘passive’ QT whereby the Bank allows government bonds to reach maturity. When this happens, the Treasury must make additional payments to cover the APF loss so the APF may repay its loan to the Bank of England. When this loan is repaid, the Bank uses this money to cover reserve remuneration. Here, because the BoE is sending money to commercial banks (a private sector surplus) - and not returning it back to the Treasury - the government is experiencing a very real fiscal loss (this is where the bill comes from). 

However, the Bank is not just allowing the bonds to reach maturity; it is actively selling them. Here, the APF experiences a ‘valuation’ loss where, due to a higher bank rate, the market value of the bonds decreases, creating a difference between the original purchase price and the current selling price. 

Again, the Treasury must cover this loss, but the difference between the APF interest and valuation loss lies in the fact that valuation losses from active QT are fast and quick, but they place a much higher strain on government finances in the short-run. So, was I wrong? Maybe, but I’d like to say only partly. 

APF interest and valuation losses only occur due to a higher bank rate - not because of the QT operation on its own. Active QT places a higher strain on public finances as it manifests higher valuation losses in the present, which, right now, are particularly costly because of high interest rates. The Bank predicts that a longer QT unwind would still manifest similar total costs (due to APF interest losses), but this depends on the future path of interest rates.  

If interest rates were lower, a passive QT programme would burden the Treasury with a smaller sum of losses due to reductions in the APF interest loss. Depending on how you view things, this is a win for debt sustainability (and the crux of Reform's plan).  

Let me clarify what I mean by this, and first of all, I certainly don’t care for fiscal rules. Yes, lower interest losses would be good for sticking to fiscal rules. And, yes, while both passive and active QT programmes appear to damage fiscal rules, this really does not matter in fundamental economic terms. As proposed by Blanchard, debt sustainability dynamics are determined by the difference between the rate of interest and the rate of growth. If economic growth is higher than the interest rate (in real terms), the size of the primary deficit does not matter. 

This is the point that I was aiming to make in my previous article, the outflows from the Treasury to the Bank are only ‘hurting’ public finances because we are in an era of high interest rates. Thus, while I was wrong to say that changing government obligations creates no losses, I will still stand by the statement that the higher interest rate is the source of deteriorating public finances and not QT itself. 

Of course, the current context of high interest rates does mean that it may be a good idea, from a fiscal perspective, for a shift towards a passive QT stance to make the size of immediate monthly QT payments more manageable for the Treasury. 

However, this would raise questions surrounding central bank independence. The Bank’s QT programme is intended to meet a PMRR target. If you’re a monetary policy nerd like me, I recommend reading into it.

If the Bank decided to slow down the pace of its QT programme, it would effectively be prioritising the fiscal position of the government over its own policy objectives. Unless the current pace of QT poses a financial stability risk, then a change in direction from the Bank towards a more passive QT programme could be a sign of reduced central bank independence. 

What is to be done? Well, there are other solutions to this, like changing the indemnity agreement (the Fed has a different approach), but this article is already getting long. Go, treat yourself to a pint - maybe join the Bank’s hangover club - and know that if there was a monetary policy pub quiz, you’d be a winner.