Reform UK Party’s manifesto: Bank of England should not pay interest on reserves

It is interesting when central bank policies become part of manifestos of political parties.

Reform UK Party (led by Nigel Farage) in its manifesto has pledged that it will ask Bank of England to not pay interest on reserves. If elected, the party has listed the critical reforms it will undertake in first 100 days. The collective reforms will save GBP 150 billion annually. Of the several reforms, BoE not paying interest on reserves will lead to a to saving of GBP 35 billion:

Bank of England Must Stop Paying Interest to Commercial Banks on QE Reserves
This approach would save around £35 billion per year and has been endorsed by senior figures at the Financial Times, New Economics Foundation, and IFS, as well as two former Deputy Governors of the Bank of England.

Let’s understand this discussion.

What are reserves?

Central banks regulate commercial banks to keep a certain percent of liabilities as reserves with the central bank.

What is interest on reserves?
The central banks did not pay any interest on the reserves.  Post 2008-crisis, the developed country central banks started to pay interest on reserves to anchor policy rates. Bank of England also decided to pay interest on reserves.

What is QE Reserves?
Apart from paying interest on reserves, Bank of England (like other central banks) started a program named Quantitative easing. Under this, the central bank purchased securities (mainly govt bonds) from the financial markets. Central bank buys securities from the banking system and pays by crediting reserves of the banking system. Ideally, banks should lend/invest these newly created reserves. However, in case there are not enough lending/investing opportunities, the banks can depoist the reserves with the central bank. These reserves over the required reserves are QE reserves. The central bank also pays interest on these QE reserves.

How will Treasury make gains if BoE stops paying interest on QE reserves?
Before understanding this question, some more details are needed.

For doing QE, Bank of England and UK Treasury set up an Asset Purchase Framework (APF). Under the APF, the profits from buying/selling securities will be shared with the Treasury.

Asset purchases carried out as part of QE programmes are conducted through the APF – which operates via a subsidiary of the Bank indemnified by HMT.  The assets held in the APF generate a range of cash flows which drive consequent cash transfers between HMT and the APF. This box explains the cash transfer arrangements, with a focus on the primary factors that affect the size and direction of cash flows. This consolidates and builds on details provided in earlier Bank publications and speeches, and provides an updated analysis of cash flow transfers to date.     

The APF was established in January 2009 to purchase high quality assets on behalf of the Bank as part of the MPC’s policy of QE. Through these purchases, the APF owns a large number of gilts that pay regular coupons. This coupon income flows into the APF and is used to pay for interest expenses (since the APF’s purchases are funded by a loan from the Bank, with interest charged at Bank Rate) plus operating costs, as well as offsetting any difference between the purchase and redemption (or sale) value of gilts.

From 2009-22, as interest rates remained low, APF accumulated profits:

Since 2009 the APF’s activities have generated positive net cash flows, totalling £126bn (February 2022).

Instead it was agreed to transfer coupon payments, net of interest and operating costs, plus any difference between the purchase and redemption (or sale) value of gilts, to HMT. To date a cumulative £120bn of cash transfers have been made from the APF to HMT. These transfers are in essence a transfer from one part of the public sector balance sheet to another which, as set out at the time, helps to facilitate more efficient cash management across the public sector as a whole.

Post 2022, as central bank raised interest rates, scenario began to change:

When this arrangement was put in place, it was recognised that reverse payments from HMT to the APF were likely to be needed in the future as Bank Rate increased and as the APF’s gilt holdings were eventually unwound by the MPC. The first such quarterly transfer from HMT to the APF occurred in October 2022 and payments have been made on a quarterly basis thereafter.

As per latest projection, APF will have negative cashflows going forward:

Since the current value of cash flows further into the future is generally lower than the value of cash flows in the nearer term, the net present value (NPV) for past and future projected cash flows are calculated for each of the scenarios to facilitate a comparison between them. Depending on the assumed path for Bank Rate, the illustrative cumulative lifetime NPVs of cash flows in the scenarios considered fall in the range between -£45 billion and -£85 billion.

So, the Treasury is expected to foot the bill.  If the central bank stops paying interest on QE reserves, the central bank could use the money to lower the bill.

Overal, quite a complicated way to shore up savings. Even more complicated to see a political party mention it in their manifestos of all places..