How does this alchemy work and what are the implications?
Since the Bank of England began quantitative easing in March 2009 the accumulated coupon payments (gilts pay coupons twice a year) have not been re-invested. These coupon payments are set to reach £35bn by the end of the 2012/13 fiscal year and are held in the Asset Purchase Facility. It is this cash pile that the Chancellor has decided he would like to get his hands on.
The Treasury has stated that remitting coupon payments to the Exchequer simply brings the UK into line with the practice of other countries that are pursuing quantitative easing, namely the US and Japan. This is a reasonable comment.
However, the timing of the change looks suspiciously convenient for the Chancellor, coming ahead of the Autumn Statement on 5 December. The expectation for this statement was that the Chancellor would have to concede that the public finances were not improving as hoped and the borrowing requirement would have to be increased.
Last Friday’s accounting wizardry will now avoid this embarrassment.The effect of this action will be to reduce the deficit and therefore gilt issuance by around £11bn this fiscal year (around 0.7% of GDP) and by around £35bn in the 2012/13 fiscal year (around 2.3% of GDP).
So what’s not to like?
There are many aspects of this decision that appear reasonable. However, the point we find concerning is that the motivation for this move clearly came from the Treasury and not the Bank of England.
In fact, this easing of monetary policy was not even discussed by the MPC but rather delivered as a fait accompli by the Governor based on his prior arrangement with the Chancellor. The Bank of England kept policy unchanged on Thursday and the Treasury eased on Friday. The impression that the central bank is funding government expenditure can be extremely dangerous and the UK will pay a heavy price if the taint of monetary financing attaches to the gilt market.
Of course, the Bank of England has argued that it is not engaged in monetary financing as one day the gilts it has purchased will be sold back. That said, the shortest-dated gilt the Bank bought is due to redeem in March 2013 and the longer policy remains on hold the more of its portfolio of gilts will approach redemption.
At the moment the gilt market is taking comfort from the reduced amount of issuance that this change will entail. However, the UK must avoid the impression of a blurring of the fiscal and monetary authorities, which would result in far higher political and inflation risk premia attaching to the gilt market.
