Bank of England governor Mervyn King may have told economists this week, that the Bank had no immediate plans to change the rate paid to commercial banks on sums deposited overnight, but it appears not everyone believes him.
Among those still speculating the Bank will cut remuneration rates — and do so soon — is Morgan Stanley analyst Melanie Baker.
In a note published on Friday she writes (our emphasis):
The Bank of England is considering lowering reserves remuneration on a portion of commercial bank reserves held with the BoE. Notwithstanding the market recently re-pricing the probability of this happening, we think that such a move is likely and could come as early as November. QE works through a variety of channels, but this might make the reserves accumulation channel more effective — i.e. incentivise the banks to do something with their increased reserves other than just sit on them. The effects would likely be 1) to lower SONIA, 2) lower short-term gilts, and 3) portfolio rebalancing, which could spark a further rally in risk assets.
As Baker states, the move would likely lower the sterling overnight interbank average (Sonia), bringing the BoE’s policy more in line with that of the ECB which has already allowed Eonia to trade more than 60bp below the official rate, via stealth easing policies like the adoption of full-allocation repos.
This would, however, break the Bank’s previous policy of keeping the Sonia in line with policy rates.
At this point, however, it’s important to remember that the Bank of England suspended reserves-targeting with the start of QE, remunerating commercial bank reserves at the policy rate of 0.5 per cent. Use of the existing deposit facility, where remuneration is set at 0 per cent, has therefore been zero.
Pre crisis, banks always had the right to set their own reserves target knowing that up to 2 per cent of their “sterling eligible liabilities, as calculated for Cash Ratio Deposits purposes,” would be remunerated at the policy rate. In the second quarter of 2008, the Bank increased this ceiling to 5 per cent.
Currently, Baker says there is about £2,200bn worth of eligible bank liabilities at UK banks. A return to the old 2 per cent system, therefore, would allow £43bn of reserves to be remunerated at the policy rate. To compare, aggregate reserves currently stand at about £138bn.
As Baker explains, the move to cut the remuneration rate, therefore, could be considered part of the BoE’s forward planning to bring policies back towards the old regime once its gilt purchase programme ends:
To understand what might happen to SONIA after the BoE’s Gilt purchase programme ends, it is important to realise why SONIA has been trading close to the policy rate during the QE period. QE asset purchases have been funded by central bank reserves.
Each asset purchased is effectively funded by a claim on the central bank — the level of commercial bank reserves held at the central bank had therefore been rising in line with asset purchases4. If the Bank of England had not both suspended reserves targeting and undertaken to remunerate all reserves at the Base Rate (otherwise banks would be heavily using the deposit facility, currently at 0% rate), this vast increase in reserves would surely have pushed SONIA well below the 0.5% policy rate. SONIA had already been pushed significantly below the policy rate between October 2008 and March 2009 when Banks were using the operational standing deposit facility in significant size and SONIA traded at 25bp-50bp below the Base Rate.
In that respect, not only is it likely that the BoE will lower reserves remuneration on only a portion of commercial bank reserves, it’s also likely the move will coincide with the end of its QE programme. As she concludes:
In November, the MPC will get the opportunity to review their forecasts for inflation and GDP growth in depth. In our view, they are likely to end QE, but to remain cautious about the sustainability of the recovery. They will want to avoid signalling future tightening. One way of doing so would be through adjusting reserves remuneration and guiding SONIA lower.
An announcement as soon as the October MPC meeting seems possible. However, that would be rather pre-empting an end to QE in November. Hence it doesn’t seem to be the most likely outcome. Furthermore, any decision on this won’t be taken lightly and would we expect that there would be significant internal research carried out at the BoE before any change. Any major change to the framework would presumably also be accompanied by an external consultation.