The cheap money illusion that will cost taxpayers billions for years to come

Andrew Bailey was less than a week into his new job as Bank of England Governor when policymakers crossed the Rubicon.

It was March 2020, and the Bank had just launched a £200bn money printing spree to calm financial markets as it became clear lockdowns were approaching. The money would be spent on government bonds held by banks to free up cash in the system to keep the economy turning.

Yet the first blitz of so-called quantitative easing (QE) during the pandemic came the day before then chancellor Rishi Sunak announced a furlough scheme that would subsidise wages up to £2,500 per month.

Reflecting on the actions of that weekend, Bailey acknowledged to colleagues that the Bank was “funding the government deficit de-facto” by hoovering up debt already held by commercial banks, freeing them up to buy newly issued bonds.

“Our predecessors will be turning in their graves,” sources recall him saying in a memo, although Bailey was also quick to note that the Old Lady was not the only central bank effectively printing money to bankroll the Government.

At the Treasury, Sunak was in panic mode after a usually pedestrian auction of short-term Treasury bills failed to attract enough demand, which had not happened since 2008.

The former Chancellor estimated he would need up to £500bn of debt to be issued to ensure the Government could pay all its bills.

Bailey told Sunak by phone that he viewed monetary financing – printing money to directly fund the Government – as unacceptable, though the Governor later admitted publicly that the Government would have struggled to fund itself if the Bank had not intervened.

Realising the Bank was in uncharted waters during extraordinary times, Bailey even floated the idea of facilitating a vehicle that could buy UK equities, which advisers said had been done in the 1930s, to support the economy.

In the end, the Bank stuck to bonds, amassing a warchest of more than £850bn at the peak.

Many economists and politicians believe QE has helped to stoke inflation. Yet that is not the only price of the policy. The costs of maintaining this huge debt stockpile are mounting as borrowing costs rise.

In the second of our three part debt series, we examine the true cost of the Bank’s money printing programme and unpack how bad policy choices could end up costing the taxpayer tens of billions in the years to come.

From the start, everyone claimed they knew QE wasn’t free money.

The novel policy was always meant to be temporary and extraordinary, forged out of necessity during the heat of the global financial crisis.

When Labour Chancellor Alistair Darling first authorised the so-called asset purchase facility (APF) to hoover up £50bn of bonds in January 2009, he assured the public that the impact on the public finances would be “mostly temporary”, with assets “held for no longer than is necessary to ensure stability and protect taxpayer interests”.

Lord King, then Governor of the Bank of England, also stressed in a letter to Darling that Threadneedle Street would wind down its portfolio of assets when normality returned, and “consider the appropriate mechanisms” for selling them “having due regard for the impact of those sales on the prices achieved”. In other words, the Bank would be careful not to flood the market with gilts and distort prices.

Officials put financial stability and value for money at the heart of any intervention. However, it quickly became clear that bond purchases were becoming a serious money making tool for the Bank.

QE works by creating reserves that commercial banks hold in the form of deposits at the Bank. Threadneedle Street pays interest on those reserves at the current base rate.

When interest rates were at record lows of 0.5pc and then 0.1pc during the pandemic, the Bank earned far more on the returns from government bonds it bought than it had to pay out in interest. The Old Lady was in profit.

As the gains mounted, the Government began to notice.

Andy King, who worked in the Treasury as a civil servant at the time and later as an official at the Office for Budget Responsibility (OBR), the Government’s tax and spending watchdog, says: “It built up and as we got to £20bn, all of a sudden the ideas for what you could do with it started coming in. That was when the Treasury concluded it doesn’t work to have a big, tempting pot of money that is reported on every quarter, because it’s just not politically going to hold.”

In 2012, Chancellor George Osborne took a decision that still has consequences today – he decided to start transferring these profits to the Treasury.

Osborne claimed the move would allow the Government to “manage its cash more efficiently”, insisting the move was “solely to benefit the public finances and to reduce debt”.

Everyone else saw an accounting trick that enabled him to conduct what was a multi-billion raid on QE profits.

Lord Macpherson, a permanent secretary to the Treasury at the time, says: “They wanted to take credit for the profits to show that borrowing was in fact lower.”

It was a devil’s bargain. When QE had been agreed, Darling had promised the Government would pay for any losses incurred by the Bank on gilts in an effort to prevent a black hole on the central bank’s balance sheet that could skew decision making.

By spending the QE gains when times were good, it only made it more painful to meet those losses when the economy turned.

Lord Macpherson,  who once compared QE to “heroin”, says: “That made it inevitable that you would have to pay for these losses later on. Had the ring fence remained in place, the losses now would be far more easy to absorb.”

Profits would end up rising to £123.8bn at their peak in September 2022.

By then, Osborne was long gone. His pledge to only spend QE gains on paying down debt had also fallen by the wayside.

Andy King says: “During the Osborne years, austerity and fiscal rules went hand in hand, and then you can see particularly with the 2019 government, it wanted to end austerity so it increased spending.

“As time went on, post-Osborne, fiscal targets kept getting looser, and the headroom against them kept getting smaller.”

While profits from QE peaked just over a year ago, the rapid rise in interest rates since then has brought with it an astonishingly fast change in fortunes for the Government.

QE losses arise as the interest the Bank pays commercial lenders outstrips income from gilts, or as bonds are sold at a loss.

The Treasury is on the hook to make up the difference – and it must pay up in short order. It has transferred £29.1bn to the Bank over the past year alone.

Deutsche Bank notes that “no other major central bank has had to register such losses as direct and immediate consequences to the public finances”.

Andy King says: “It was recognised that you go up the hill and then you come back down again. But the best way of dealing with that at the time was to leave the money in the APF [asset purchase facility], because then no one could get it out.”

Alas, that money is spent and Jeremy Hunt is left scrambling to find new cash to plug the gap.

Sanjay Raja, chief UK economist at Deutsche Bank, says that the Bank’s decision to actively start selling bonds back into the market has also increased losses for the taxpayer.

Bond prices fall as yields rise. The high interest rate environment is pushing up yields and thus depressing bond prices. It means the Bank is selling most of its debt at a loss.

Official data show the Bank has suffered £11.7bn of losses from active gilt sales alone this year.

Deutsche Bank argues that the Bank could limit these losses by being more selective about the bonds it sells. At the moment, it follows a rigid rule of thumb where sales are split evenly between short, medium and long term debt.

The Bank is losing much more money on its long-dated bonds because interest rates have settled “materially higher relative to when they were purchased,” says Deutsche Bank. Long-dated debt, traditionally favoured by pension funds, is therefore particularly unloved at the moment.

The bulk of the Bank’s losses from sales – £7.5bn – have come from long dated debt of more than 20 years. This represents a 50pc loss at the point of sale, says Deutsche Bank.

The Bank is reducing its gilt portfolio based on value rather than volume, targeting £100bn a year split between gilts maturing and the funds not being reinvested and active sales.

Facing a 50pc loss on some bonds, the target suggests the Bank has to sell double the amount of gilts at a cut price in order to meet the target.

This creates a “disproportionate loss” that Deutsche Bank estimates is costing the taxpayer an extra £15bn-a-year alone because of the active sales.

Raja says the losses would be spread more evenly if the gilts in question were simply allowed to mature, rather than crystallising the steep losses today through sales. He highlights that money transferred to the Bank is money that cannot be spent on other things.

“The additional cost of active QT [quantitative tightening, as the bond unwinding is known] adds to the Chancellor’s debt burden, taking away some space for spending or tax cuts in the near-term particularly given the narrow headroom he has in meeting his debt rule.”

Insiders say an analysis published in December by Deutsche Bank pointing out the design flaws of QT has caught the Treasury’s eye and officials have been asking questions about how the scheme can deliver better value for money.

QT decisions are taken by the Bank, which has operational independence. But Chancellor Jeremy Hunt has stressed in recent exchanges with Bailey that “value for money” remains paramount.

Lord Macpherson believes it would be “difficult to change the rules” now, “particularly because the Government made profits in the good times”.

“Just because it makes losses, you don’t now change the way reserves are remunerated.”

But he adds: “My guess is there will be increasing political pressure to do something about this, either putting pressure on the Bank, which I think would be undesirable, or potentially taxing banks more, who have been the beneficiaries of this policy.”

Andy King, who left the OBR this summer, says: “The lesson I would take is that when it comes to political economy and anything to do with the public finances, having a pot of money is untenable. It will be spent.

“And it’s unfortunate that headroom against fiscal targets is seen precisely as a pot of money, not something that you build up because the future is uncertain. Nobody has looked at QE gains and said: well, it got to £124bn and so headroom needs to be at least £124bn.

“There was a commitment a long time ago that fell by the wayside. And the cost has come home to roost at a really unfortunate time.”