Hidden benefits of lower rates for public purse

Forecast cuts to Bank Rate will reduce the interest bill on state debt by billions, paving the way for tax cuts

The new year has brought a flurry of optimism about prospects for lower interest rates. A consequence has been that mortgage lenders are competing to offer better deals. Mind you, no one is admitting that these lower mortgage rates will be matched, and probably over-matched, by reductions in savings rates – much to the chagrin of millions of Britons.

But there is another potential benefit from lower interest rates that is not receiving enough attention, namely the potential improvement to the public finances and hence the scope for tax cuts. The policy of quantitative easing (QE) has had a dramatic effect on the exposure of the public finances to short-term interest rates. (Warning: this is where things get a bit tricky. You may need a ready supply of hot towels.)

Under this policy, the Bank of England bought in gilts and effectively paid for these purchases by issuing new money, which the commercial banks held at the Bank of England, receiving interest at the Bank Rate.

While the Bank Rate was extremely low, this policy was a real money spinner. Gilts with interest costs that might be as high as 4pc or 5pc were financed by deposits earning interest at the Bank Rate, which, at the low point, was only 0.1pc.

The profits from this money-goround were transmitted from the Bank to the Treasury. Looking at the Bank and the Treasury as one combined unit, this meant that the Government was borrowing at only 0.1pc.

More recently, however, this bonanza has gone into reverse. At 5.25pc, the rate paid to the banks on their deposits with the Bank of England is now much higher than the income received by the Bank on its gilts. The sums are enormous. The amount of reserves held by the commercial banks with the Bank of England stands at about £800bn. The total interest bill on public debt is running at over £110bn per annum and, of this, about £40bn corresponds to the amount of interest paid by the Bank of England to the commercial banks.

This is where lower interest rates come to the rescue. Each 1pc off the Bank Rate would reduce this interest bill by about £8bn. On top of that there would potentially be a drop in gilt yields and hence a reduction in the cost of gilts issued to finance new borrowing, as well as a reduction in the cost of refinancing maturing gilts.

If gilt yields were 1pc lower then, by the end of the forecasting period in 2028-29, the annual interest payments on gilts would be about £10bn lower. (Given that the Bank holds about 30pc of the total gilt stock, the overall saving to the public purse could be a bit lower.)

Of course, the Office for Budget Responsibility (OBR) has to make assumptions about interest rates and bond yields, which it bases on the forecasts implied by current financial market prices. In its latest projections made to accompany November’s Autumn Statement, the OBR assumed that, over the next financial year, the Bank Rate would average 5pc. Yet the financial markets are now implicitly forecasting that the Bank Rate will average 4pc. And the OBR’S assumptions for later years are also about 1pc above the markets’ current forecasts.

Similarly, its assumptions for gilt yields in future years are also now about 1pc above market forecasts. Of course, the markets are not perfect forecasters and they change their views at the drop of a hat. But on the above, simple calculations, if the OBR was revising its projections now, it would reduce its forecasts for the debt interest bill and increase the implied scope for tax cuts, by about £18bn.

With a few tweaks, the numbers could be different. The OBR itself puts the effect of a 1pc change in all interest rates on total debt interest in 2028-29 at £18.7bn. Furthermore, there is something that could offer the Treasury larger rewards. Why do deposits held by the banks at the Bank of England receive any interest at all? After all, such interest only started being paid in 2006. And none other than Charles Goodhart, a former senior Bank official and former member of the MPC, has suggested that the payment of interest could be suspended. The savings could be as much as £40bn per annum. (Mind you, it would be correspondingly lower as Bank Rate fell.)

There are three arguments against. First, if no interest was receivable, the banks would try to get rid of their excess reserves by bidding down interest rates offered for deposits, doing all they could to increase lending and buying assets. Accordingly, the Bank would lose control of monetary policy and there could be a substantial increase of the money supply. But in the old days there used to be something called “special deposits”, which amounted to deposits that the banks had to keep at the Bank but that could not be used. Effectively, they impounded banks’ spare cash.

Second, such a huge impost would deal a devastating blow to the profits of

UK banks, which wouldn’t exactly be desirable. In that case, however, the policy could be scaled back. Banks could continue to earn interest on some of their reserves and only lose entitlement to interest on the excess above this threshold, as happened between 2006 and 2009.

Third, whatever the amount, effectively “taxing” the banks in this supplementary way would be unfair and distortionary.

Yet, if the banks aren’t paying this “tax”, then someone else in the economy is having to pay other taxes of the same amount, and these also cause distortions. Moreover, it wasn’t so long ago that the Government had to bail out the banks at a massive cost to the public purse. Time for a payback?

I can see why a Conservative Chancellor would baulk at such reasoning. It certainly isn’t a first-best policy. But, of course, we don’t live in a first-best world. Might a Labour chancellor have fewer scruples?

‘If the OBR was revising projections now, it would reduce its forecasts for the debt interest bill by £18bn’