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The UK chancellor can ease some of the budgetary impact of bond losses suffered by the Bank of England without spooking financial markets, say investors, as the new Labour government prepares for a tough Budget this autumn.
The Treasury could nearly triple its fiscal “headroom” — the space for extra borrowing under its own debt rule — by excluding the impact of losses being racked up on the BoE’s asset purchase facility (APF) on its finances, according to analyst calculations.
While chancellor Rachel Reeves has suggested she does not want to change the definition of debt that is targeted by the government and monitored by its Office for Budget Responsibility, investors say such a move would be logical and would be swallowed by the markets as long as any extra borrowing was used for investment, for instance in infrastructure.
“Fiscal rules change all the time . . . changing the definition of debt would be my preferred option as it feels like part of a long-term plan,” said Matthew Amis, a portfolio manager at Abrdn. He added that the market seems to trust the Labour government but that could be eroded quickly if changes were simply viewed as a way to avoid public sector cuts.
Quantitative easing by the BoE swelled government receipts as interest payments on its bond holdings flowed back to the Treasury. But the operations have now become a burden on the public finances as the central bank sells bonds back to investors at a loss, which the government has to cover.
Analysts at JPMorgan calculate that by excluding BoE losses from the Treasury’s rule that debt must be falling as a proportion of GDP by the end of its five-year forecast period, the government would boost its budgetary wriggle room to £25.8bn from just £8.9bn estimated in March.
“I don’t think they would spring a change to the debt rule as a surprise, but if they slowly build up a consensus, they could remove BoE losses on the APF from the current key metric,” said Allan Monks at JPMorgan.
“This would create around £17bn of extra headroom, which the Treasury could use to increase borrowing for investment,” he said, adding that a change was more likely next year than this autumn.
The Treasury this week will publish plans to strengthen the OBR’s oversight of the public finances as part of the King’s Speech on Wednesday. Labour has been keen to portray itself as fiscally conservative as it draws a dividing line with the policies of Liz Truss, who provoked turmoil in the gilt market during her brief stint as prime minister in 2022.
Widening the scope of the OBR could then pave the way for further changes to the UK’s debt rules to help free up more spending.
“The bottom line is that Labour will need to be creative with the finances as there is no money left in the kitty and if they want to get off to a strong start in power then they will need to create some wriggle room,” said Craig Inches, head of rates and cash at Royal London Asset Management.
Reeves has said she would continue the previous government’s fiscal rule that debt to GDP must be forecast to fall in five years’ time. She has also warned against overhauling how the BoE pays interest to commercial lenders on their reserves, a move that could save billions of pounds per year.
A Treasury spokesperson said: “Economic stability can only be achieved if we are responsible with public finances, which is why the Chancellor is committed to robust fiscal rules, as set out in the [Labour] manifesto”.
Michael Saunders, an economist at Oxford Economics and a former member of the BoE’s Monetary Policy Committee, said Reeves’s instincts were probably not to do anything that appeared risky, so she would have to be very sure it was acceptable to investors to remove APF losses from its fiscal rules.
“But I think it probably would be [acceptable],” he said, adding that the BoE had probably not envisaged quantitative tightening — reducing holdings of bonds bought during QE — having such significant fiscal side effects.
“It is sensible,” he added. “You can only do it in the context of a broader fiscal tightening, but it looks like Rachel Reeves is going to do that.”
The idea of tweaking the net debt metric would be a less radical shift than some other ideas for handling the big BoE losses on its bond portfolio.
Earlier this month analysts at Barclays suggested that the government could transfer the assets held in the APF to the BoE’s own balance sheet. That would in turn allow the central bank to treat losses from its gilt portfolio as a “deferred asset” — similar to the US Federal Reserve’s practice — which would save the Treasury having to cover them.
However, changing the accounting treatment of the APF could be seen as changing the rules halfway through the game, potentially weakening the credibility of any future BoE market interventions.
“The important thing is to do any change within the guardrails of an operationally independent central bank with a clear mandate for inflation targeting,” said Jack Meaning, an economist at Barclays.