Why the OBR’s QT assumptions could be worth £15.5bn to Rachel Reeves

The Bank of England’s Monetary Policy Committee today announced it will keep the quantitative tightening limit at £100 billion.

As a result, the reduction in the Asset Purchase Facility over the next year will consist of £87 billion of bonds maturing and rolling over, and £13 billion of active sales. From the summary:

The MPC also confirmed that there would be a high threshold for changing the planned reduction in the stock of purchased gilts outside a planned annual review. This was to remain consistent with the principles that the bank rate should be the active policy instrument in adjusting the stance of monetary policy, and that the APF reduction should be predictable.

This is what was expected (although not universally), so it’s not a huge shock. But because the UK is a foolish country, it could be hugely important.

There are two things here.

First from Szu Ping Chan, a former colleague of the author, at the Telegraph:

Rachel Reeves has been handed an extra £10bn in funding ahead of the Budget after the Bank of England said it would slow the sale of government bonds accumulated during the lockdown.

Second, from Tom Rees, a former colleague of the author, at Bloomberg:

(T)he BOE is sticking to a £100bn run-off for a third year, meaning the OBR could adopt a new assumption that this pace will continue. Bloomberg Economics calculates that this would reduce the Chancellor’s already limited room for manoeuvre by a further £5.5bn.

So £15.5 billion of financial space – money that could be spent on things like hospitals for sick orphans, or tickets for Keir Starmer to see Arsenal play – depends on the OBR’s assumptions.

Two important points that you all probably already know:

— QT is bad for the government because QT causes the BoE to lose money, and the Treasury has to replace those losses.
— UK fiscal rules require that the national debt must be reduced by the end of the five years following a fiscal event. This means that debt is limited by the forecasts of the OBR, the government’s fiscal watchdog.

And it’s time to tap the board so we’re all on the same page:

Let’s quickly unpack how we got here. The Bank of England launched its active quantitative tightening process in the autumn of 2022. Over the following year, it cut the APF by £100 billion, made up of around £39 billion of maturing bonds rolling over, £42 billion of active gilt sales, and £19 billion of corporate bond sales (thanks to Elliott Jordan-Doak of Pantheon Macroeconomics for helping to compile these numbers):

In the second year of the programme (now coming to an end), the APF will be reduced by £100 billion, including £46 billion of maturing bonds being wound down and, implicitly, £54 billion of active government bond sales:

The Bank of England’s target for the current year is £100 billion has been known since September last year.

Armed with this information, the OBR (whose decisions are material because they determine the amount of room for manoeuvre available under the fiscal rules) had to make a decision ahead of the March economic and fiscal outlook: what was more likely – that the BoE would continue to aim for a £100 billion a year cut; or that the BoE would be agnostic on the pace of passive tapering and instead aim to maintain a consistent level of active selling?

The bank opted for the latter and determined – by simply averaging the results of the first two years – that the BoE would decide to conduct £48 billion of active sales in the third year of QT, taking the total amount to £135 billion (£87 billion passive + £48 billion active).

On hindsight, a continuation of a £100bn-a-year rate of reduction seems obvious. But there were credible arguments for both scenarios (when the BoE set the £100bn envelope for year two, the minutes noted that “the Committee placed some emphasis on continuity in the pace of sales”), and the sell-side has been muttering all year about which way the MPC would go. We don’t really blame the OBR for choosing the way they did, but we have to live with the consequences.

However, it has also long been known that the third year of QT would be a strange one: that’s because an unusually large number of government bonds in the APF are about to mature – the £87 billion we mentioned earlier.

So we are looking at a big slowdown in active sales in the coming quarter. What are the implications?

Well, that’s up to the OBR.

It’s worth quickly reminding ourselves why the UK’s tax rules are crap: things only matter on a rolling five-year horizon, meaning that current decision-making is constantly held hostage to assumptions and extrapolations over half a decade’s time. And this is a perfect example of the OBR making big assumptions about a big area.

As far as we can see, there are three clear paths:

Option 1) The OBR sticks to its previous methodology and estimates the future sales pace to be an average of £42bn, £54bn and £13bn over the first three years. That would give it a figure of £36.3bn of active sales per year, a kind of middle ground:

Option 2) The OBR assumes that £13bn of active sales is the pace going forward. This is, dare we say, rather optimistic estimate used by Goldman Sachs in a June note that forms the basis for the Telegraph article — and the ideal one for Treasury Secretary Rachel Reeves:

As Goldman wrote then:

We estimate that if the OBR instead assumes a rate of £13 billion of active sales going forward, that resistance would be reduced by around £10 billion. We think the next government is likely to use the extra fiscal space to slow the pace of fiscal consolidation.

Option 3) The OBR takes an EXTREMELY STRONG TIP from the fact that this has been policy for three years running that the BoE will continue to aim for an overall reduction of £100bn, and will therefore adjust active sales over the coming years to meet that target:

This also seems like the most pessimistic outcome possible in terms of the implications for government finances. As Dan Hanson of Bloomberg Intelligence, who created the assumption used in the Bloomberg News piece, wrote earlier this month:

If the OBR decides to adopt this assumption in the future, it would reduce the already limited headroom by £5.5 billion.

Now there’s a good chance that all this will become irrelevant, if Reeves heeds the advice of people like our learned MainFT colleague Chris Giles and changes the debt metric the government is targeting to exclude QT losses. As he wrote last month:

It goes without saying that the UK should not base fiscal policy on the OBR’s forecast for QT five years into the future.

We agree! And it is even worse when said forecasts are based so heavily on total guesswork by the OBR, and even worse when they are based on assumptions about the scale of policy that could suddenly stop when the BoE reaches its desired minimum range of reserves (or before).

So let’s hope for change, otherwise the OBR will become too big and the Emirates will quickly find themselves in trouble compared to Ødegaard and Starmer.

Read more:
— Does the Bank of England have a plumbing problem? (FTAV)