Forget the Budget — there’s a more important economic date coming up
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The Budget on October 30 is set to be an important tax raising statement, but it might not be the most crucial UK economic decision to be made this autumn. For that, you should look to Bank of England’s monetary policy committee meeting on September 19. Its significance lies not in the likely decision to hold interest rates at 5 per cent, but what is set for the path ahead for quantitative tightening.
The BoE has already reduced stock of money printed under the quantitative easing schemes that ran from 2009 to 2021 from £895bn to £688bn. Officials have suggested that at the September MPC meeting they are likely to keep the pace of QT similar in the year ahead, suggesting the stock of assets held by the central bank is likely to fall roughly another £100bn. That would leave the stock in September 2025 around £550bn.
The decision on future QT matters for three reasons. First, at the margin, more quantitative tightening puts upwards pressure on gilt yields because the private sector has to absorb the assets the BoE offloads, either when it sells them or they mature and the government issues new debt. They will demand compensation. The BoE believes the additional government borrowing costs of QT is small — about a 0.1 percentage point increase in interest rates on 10-year government debt for every £80bn sold — but these estimates have a margin of error you can drive a truck through. The MPC can, of course, offset higher government borrowing costs with lower official interest rates, so the more QT it chooses, the more interest rates are likely to fall.
Second, the decision to reduce the QE stock will all but eliminate the excess money held in the banking system. The BoE thinks that UK banks require somewhere in the region of £345bn to £490bn of liquid reserves to be able to meet regulatory requirements and have sufficient balances to ensure they meet daily payment needs.
Governor Andrew Bailey wants to go further with QT, ensuring that as the level of reserves falls below the amount banks desire, they meet their needs by borrowing from the BoE against pledged collateral. Currently, reserves are indirectly created when the BoE buys gilts and the proceeds are parked by the commercial banks at the central bank. In future, if banks fund their needs more directly by borrowing from the BoE, that would leave the bank — and the public sector — with less interest rate risk. More, appropriately, would be taken by the private sector. That is welcome.
The third reason also relates to the relationship between fiscal and monetary policy and, frankly, sounds unbelievable. Since January 2022, the government’s fiscal mandate has been linked to an official measure called “public sector net debt (excluding the BoE)”. The intended idea was to ensure that central bank decisions did not have important fiscal consequences.
The unintended impact though has been that the most important variable is the action of the central bank itself. Without highlighting the gory details, the more active sales of assets the BoE undertakes, the worse is the government’s fiscal outlook on this measure. Even more absurd is that the Office for Budget Responsibility must forecast the level of active BoE QT five years hence. Currently, this reduces the fiscal headroom by £20bn. It goes without saying that the UK should not set fiscal policy based on the OBR’s forecast on QT five years into the future.
So, the most important consequence of the September MPC meeting should be that chancellor Rachel Reeves changes the measure of debt targeted by the government. Action here would give her significant additional room for manoeuvre. The September 19 MPC meeting is likely therefore to shape interest rates, normalise risk taking and kill a silly fiscal rule. This is far more consequential than most MPC meetings and Budgets.