Starmer Needs the Space Only the BOE Can Provide

(Bloomberg Opinion) — Flush from a landslide election victory in 1997, the first act of Tony Blair’s Labour government was to grant operational independence to the Bank of England. Chancellor of the Exchequer Gordon Brown followed that up by removing a generous tax credit on dividend income whose prime beneficiaries were pension funds.Neither change meant much to the average voter, but they triggered a seismic impact on fiscal and monetary policy. After nearly two decades of Conservative government, Blair’s Labour was adhering to strict budget rules but broke free in other unimagined areas to bolster investor confidence and spur corporate investment.As we approach a similar scenario after 14 years of Tory rule, and Labour riding high in the polls — don’t be surprised if we see a reprise. Call it the Blair Switch Project. Labour leader Keir Starmer and his finance chief, Rachel Reeves, are following the playbook of their electorally successful forerunners to the letter to calm the City of London’s nerves. But expect the unexpected, as the strictures of the UK’s current fiscal predicament are just too limiting for a radical policy agenda. Reeves has been deliberately vague about her plans, and her pledge to stick to fiscal rules and not raise taxes may not be as ironclad as they appear. Governments have three main levers on which to pull — raising or lowering taxes, spending and debt. The Bank of England could again be the implement that cuts through the Gordian knot of fiscal and monetary stricture.That’s because the BOE’s structure means any profit or loss from its holdings of quantitative-easing securities pass directly to the UK Treasury. This is markedly different from most central banks, and, importantly, the US Federal Reserve, which retains positive coupon income but also retains the losses from the Treasury bonds on its $7.3 trillion balance sheet.

Bank of England Governor Andrew Bailey made a potentially significant speech on May 21 at the London School of Economics. He flagged that the BOE thinks the amount of its total reserves will drop into an acceptable longer-term band of £345 billion ($439 billion) to £500 billion as soon as next year. That offers clues to how the central bank may start to pull back, or taper, its balance sheet reduction. It wants to move away from holding so many long-dated gilts and replace more with short-term repo lending. It’s encouraging usage of its repo facility, which marks a more permanent transition away from bond buying. There is scope for this to become more radical if a new government were to transform its mandate. 

By following the Fed in easing back on QT — the BOE could give itself an elegant offramp from its controversial active quantitative-tightening policy. And this could be crucial to an ambitious new government boxed in by the strict fiscal rules. Reduced QT costs would provide more room to increase spending.

After 13 years of quiet but useful profits sloshing back to the UK Treasury, this is now reversing into a hefty bill — as interest rates rose — and that cuts into government spending power. About £50 billion of taxpayers’ money has been transferred in the past year to cover BOE losses, with £200 billion more projected over the next decade. The net loss of the entire QE era could total £115 billion.

The BOE has been the most aggressive central bank in disposing of government bonds amassed during the global financial crisis and pandemic. Not only does the BOE no longer reinvest maturing holdings, known as passive QT, but it actively sells parts of its portfolio back into the market. Its zeal in reducing its balance sheet, which added an anchor to the economy now seems to waning — perhaps after criticism from parliamentary finance committees. Central bank independence doesn’t mean it’s ignorant of political headwinds. 

The BOE holds £701 billion of gilts, down from a peak of £875 billion in 2022. With maturities alone over the next year, this should drop to £588 billion by September 2025. The BOE’s September annual QT program review could likely see an end to active QT. With an increase to £90 billion of maturities next year — from £50 billion this year — there’s less need to continue piling up losses that come from selling at prices well below purchase costs. 

There are lots of radical changes needed for the UK economy, but Labour starting with the central bank could be the key to unlocking the solutions. 

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Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.

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