QE galore in the UK, and yet banks are reportedly still failing to pass on the extra liquidity. A recent report by Investec pointed out commercial banks were holding some £138bn on account at the Bank of England.
So does that indicate QE might be failing?
Popular opinion would suggest yes, at least to a degree.
For one, the debate has increasingly turned to whether the Bank might be forced to apply punitive rates on banks’ excessive reserves to boost lending — a notion no doubt encouraged by Mervyn King’s comments on August 12. When asked if the Bank would consider Sweden’s example of paying negative interest rates on reserve deposits, King replied the BoE ‘would certainly be looking at’ the idea.
Nevertheless, according to Investec, while the idea might sound logical on paper, its implementation in the UK would be incrementally less so. As they explained:
In theory yes, in practice this looks unlikely. In ‘normal’ times, short-term (i.e. overnight’) interbank rates are held close to the Bank rate by i) the Bank of England offering to lend to banks at the Bank rate; and ii) the BoE paying interest on reserves at Bank rate. Because of QE, levels of reserves are plentiful and the BoE currently lends relatively little cash to commercial banks (the main exception is a relatively small amount via the long-term repo, where the borrowing rate depends on the type of collateral offered). This plentiful level of funds puts downward pressure on market rates, while the remuneration rate acts as a floor. Hence theoretically the BoE could lower the rate paid on reserves and keep its lending rates the same.
But the effect would be to lower overnight rates in line with the new deposit rate. In effect then, this would have the same effect as a Bank rate cut and bring about problems with lending margins, which discouraged the MPC from cutting below 0.5%. Also because market rates would fall, it would not alter the opportunity (i.e. relative) cost of keeping rates on deposit at the BoE!
Regarding the Swedish example specifically, Investec added the idea wasn’t so tenable in the UK because the country’s money-market regime was entirely different to that of Sweden’s, where banks are routinely forced to square-off cash positions at the end of each day. UK banks, on the other hand, do not have a minimum reserve requirement. Further still, Sweden has not implemented any quantitative easing.
Also, while Swedish banks currently receive a negative 0.25 per cent deposit rate, the opportunity to take-up central bank fine-tuning operations that assure positive rates is still possible.
A note out from Barcap’s Simon Hayes on Monday arrived at pretty much the same conclusion. Hayes argued that while a cut to the interest rate paid on bank reserves was certainly a policy option, “it would likely require a material change in the BoE’s operating procedures” making its adoption not at all remotely imminent.
As Hayes explained (our emphasis):
Banks’ reserves held at the BoE are currently remunerated at the policy rate, Bank Rate. This rate applies to all reserves. Unlike some other central banks, the BoE does not have an operating distinction between “required” reserves and “excess” reserves. The reason for this is that, under normal circumstances, whereas other central banks stipulate a minimum required level of reserves, and so may measure “excess reserves” in relation to this minimum, in the UK reserves are demand determined: banks set their own target level of reserves at the prevailing rate and the BoE supplies this exact amount of reserves.
There are no excess reserves in this set-up. When it introduced QE, which involves, as a matter of principle, the creation of money in excess of that which is demanded at prevailing rates, the system of reserve targets became meaningless and was suspended, and the BoE said it would pay Bank Rate on the total quantity of reserves.
None of this precludes the possibility that the BoE may wish to provide some impetus to lending by lowering the rate paid on reserves. In principle, there are two ways this could be done. Most obviously, Bank Rate could be cut from its current level of 0.5%. However, this is not widely expected, and the arguments for 0.5% being the effective floor of the policy rate are intact.
(The main argument used by the MPC was that many of the lending rates offered by banks would fall if Bank Rate were cut further, but many deposit rates had already reached a floor. A lower policy rate would therefore squeeze banks’ margins and provide a disincentive rather than a spur to lending.)
A second way would be to create a distinction between “demanded” reserves and “excess” reserves and to remunerate the latter at a rate below Bank Rate. This would require a fairly substantive change in the principles under which the BoE conducts it operations, essentially demanding that the BoE move to a “required” reserve system in line with some other central banks.
We think that such a shift in operating principles is unlikely as the BoE’s operating procedures are relatively new and it views them as “state-of-the-art”. In any case, the need for further policy loosing is at present unclear, and the effectiveness of QE in improving lending flows is still an open issue – we do not think circumstances are ripe to prompt the BoE to reconsider its operating framework.
A final point worth reiterating is that this particular hare was set running not by the BoE itself but by a journalist in the Inflation Report press conference who asked whether such a move was possible. Governor King did not rule it out as a potential measure – and one lesson from the financial crisis is surely “never say never” – but it is not something he or other BoE officials have raised unprompted.
In short, a complete BoE-policy overhaul would be needed before anything close to a negative deposit rate was possible. Although, given the unprecedented action already taken by the Bank, we would argue even that cannot be ruled out.
Related links:
Uber-QE - FT Alphaville
Negative interest in cash, or goodbye banknotes – FT Alphaville