Column-BoE quantitative tightening target involved in ‘fiscal pokerism’: Mike Dolan By Reuters

By Mike Dolan

LONDON (Reuters) – The Bank of England may not abandon its interest rate cut bonanza this month, but Thursday’s meeting will still be significant as it will shine a light on the BoE’s delicate dance with the UK Treasury.

The BoE’s reluctance to make its second interest rate cut of the year is partly due to questions about how it will incorporate next month’s budget statement from the UK’s new Labor government into its thinking on inflation and growth next year.

The British government’s murmurs so far indicate that it will propose a tight budget. This should help the BoE in its efforts to cover the sticky “last mile” of disinflation in services and wages, and may well free up the points for faster monetary easing.

And the BoE may end up returning the favor, whether it intends to or not.

The bank is set to announce next year’s target for reducing its bloated balance sheet due to the pandemic. This “quantitative tightening” (QT) plan is technically separate from its rate policy and a program it probably hopes it can get through without much attention or disruption.

But the BoE’s QT announcement may be difficult to shuffle quietly.

This is in part because it was one of the few major central banks to engage in active bond sales to reduce its balance sheet. In other words, it’s not just allowing debt to mature and retire organically, like the Federal Reserve or the European Central Bank.

And this time, there’s a twist in the calculation – one that should affect both the BoE’s bond market activity over the next year and the new Labor government’s fiscal maths for its much-anticipated and controversial first budget statement.

At present, the overwhelming market consensus is that the BoE will simply recycle last year’s target to reduce the balance sheet by 100 billion pounds ($131.59 billion) over the next 12 months. So far, so simple – and in line with the BoE’s stated aim of being predictable.

The problem, however, is that next year will have a tougher debt maturity schedule. So a target outflow of £100bn would mean active gold sales would be 75% lower compared to totals over the past 12 months.

And analysts believe the roughly £13bn of sales needed could be completed by the end of the year, completely eliminating the BoE as a seller for most of next year.

It is likely to be a boon for bond investors – but also for the Chancellor of the Exchequer.

NO AURA?

One oddity about the QT process is that it crystallizes the valuation losses incurred on the bonds between the time the BoE bought them, when policy rates were close to zero, and now, when rates are 5%. The price of those bonds will be low in the meantime.

With the Treasury effectively on the hook for the BoE’s losses, QT narrows the government’s fiscal space and scope.

True, these calculations could only change the periods in which losses are recorded on the balance sheet, but this extra wiggle room could still be of great help to a government under pressure to fill what it claims is a fiscal hole inherited from about 20 billion. pounds sterling.

Certainly not everyone believes the BoE will stick to the 100bn QT figure for next year – so the ‘gift’ of fiscal space may not materialise.

Deutsche Bank UK economist Sanjay Raja believes the BOE may want to keep a “more consistent footprint” of bullion sales. So he sees lifting the overall QT target to deliver quarterly gilt sales of £5bn to £10bn – not least because active sales will need to pick up again next year.

The BoE’s estimate of the “steady state” of its balance sheet – that is, the size it will be comfortable with over the long term – involves at least another £230bn of reduction. That suggests the QT process has at least a few more years to run.

However, the question of whether UK Chancellor of the Exchequer Rachel Reeves will use the BoE Treasury exposure to game her own self-imposed fiscal rules is certainly a live one.

There is much speculation over whether Reeves will change the definition of “net public sector debt” he uses in his five-year debt reduction pledge to exclude BoE exposure, unlike the previous government.

The independent Institute for Fiscal Studies estimated last month that, based on the latest budget, such a move could open the government up to £16 billion. The institute also noted that the move could be justified if used for investment spending and would be tempting because it involves changes “few people understand or care about.”

But even so, the think tank said changing the goalposts to add up the numbers seemed hard to justify.

“If the government wants to borrow more and spend more, it would ideally argue to do so on its own terms rather than hiding behind fiscal games,” he added.

Whether the BoE QT plays ball on Thursday remains to be seen.

The opinions expressed here are those of the author, columnist at Reuters

($1 = £0.7599)

(By Mike Dolan; Editing by Jamie Freed)