(Bloomberg) — When borrowing costs rise, governments end up paying more interest. That fiscal blow is now landing faster than it used to.
(Bloomberg) — When borrowing costs rise, governments end up paying more interest. That fiscal blow is now landing faster than it used to.
The reason: Advanced economies are in effect paying floating rates on a large chunk of their national debts — the result of more than a decade of bond purchases by their central banks. And with short-term interest rates rising rapidly, floating-rate debt has gotten expensive.
That’s exacerbating budget disputes in countries including the US, where a debt-ceiling standoff looms, and the UK, which has seen interest costs climb the most in generations. Meanwhile, banks are reaping windfall gains.
“The underlying thing is that the state has moved some of its debt from being fixed-rate to floating-rate,” Paul Tucker, a former deputy governor of the Bank of England, said in an interview. “It will be more visible, earlier, in some countries than others,” he said. “But it’s the same everywhere.”
Under quantitative easing, central banks bought lots of government debt and paid for it by creating reserves — a kind of deposit held by banks. With short-term interest rates at zero or thereabouts, the central banks paid hardly anything on those deposits. Meanwhile, they earned interest on the bonds they held.
Technically, they were making a profit – except central banks don’t exist to make profits, and generally just refund them to the treasury. So what was really going on was that governments were saving money on their interest bills – some $100 billion annually, in the US case.
‘They’ve Disappeared’
Now the dynamic has flipped. Central banks are still receiving roughly the same amount – but the interest they’re paying out on reserves has soared, in tandem with policy rates. In commercial terms, they’ve swung from profits to losses — which are set to deepen with rates increasingly expected to stay higher, for longer.
And, for all the talk of their independence, central banks are part of the government. Interest-bearing reserves are sovereign liabilities, like Treasury bonds are, and any payments they make ultimately come from the same state coffers.
QuickTake: How Big Central Bank Gains Can Morph Into Big Losses
“A lot of people thought, OK well the central banks bought these bonds so they’re gone — they’ve disappeared,” said Christoph Rieger, head of rates and credit research at Commerzbank AG. “Get away from this thinking that there’s the central bank, and then there’s the finance ministry. This is all one consolidated balance sheet of the state. The debt is still there.”
The way finance ministries and central banks manage their financial obligations to each other varies by country — and that leads to different budget impacts. The distinction between the UK and the US is a good example.
UK: Pressure on Sunak
In the past decade, the Bank of England has handed over more than £120 billion ($144 billion) in QE profits to the Treasury. But under the UK’s rules, when the BOE runs a loss on its bond holdings, the government sends money in the opposite direction.
That’s a key reason why the government’s interest bill is forecast to double this year to almost 5% of GDP – the most since the aftermath of World War II.
It’s “one of the side-effects of QE,” Richard Hughes – chair of the Office for Budget Responsibility – told a parliamentary committee in November. “The net maturity of our debt has shortened dramatically,” he said. “Any rise in interest rates just hits the public finances a lot more quickly.”
The soaring payments may push Prime Minister Rishi Sunak’s administration to cut spending elsewhere, to meet its goal of trimming the national debt.
US: Debt-Limit Strains
The American setup differs from the UK in one way that’s important for budget arguments right now. When the Fed makes a profit, it pays the Treasury. But when it makes a loss, the Treasury doesn’t have to pay the central bank – the case in the UK. Instead, the Fed accumulates a “deferred asset” that will be paid down when it’s profitable again — which means the fiscal impact gets spread out over time.
There’ll still be a budget hit this year. For much of 2022, the Fed’s payments to the Treasury were running at an annual rate above $100 billion. This year, they’ll be close to zero. “Now the Fed’s not going to be rebating anything” to the Treasury, said Dean Baker, an economist at the Washington-based Center for Economic and Policy Research. “That’s an actual burden.”
It’s a burden that may be especially problematic given that the Treasury is currently constrained by the federal debt limit. The loss of the $100 billion from the Fed could play into partisan budget wrangling.
In the event that Republicans push for a specific deficit target, Baker said, “part of that story will be: We have this higher interest burden, another $100 billion a year. So that will mean they’ll have to have bigger cuts elsewhere.”
Who’s Getting Paid?
Meanwhile, banks that hold trillions on deposit at the central banks are getting a healthy return on them — 4.65% in the US right now. They’ll probably pass returns on to their own depositors — but maybe not for a while, said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management. “The cost of liabilities will eventually move higher,” he said, “but deposit remuneration is very sticky.”
The payments sparked a debate in the UK, where some analysts suggest the BOE should consider paying interest only on a portion of reserves – in effect, taxing the banks to save the government money.
There are lots of objections. Some say it would jeopardize the central bank’s ability to hit interest-rate targets — because commercial banks could pull some reserves and park them in other short-term money markets. Others raise issues about central bank independence from politicians.
The BOE’s chief economist, Huw Pill, has said that if the government wants to tax banks, it should do that directly — not via stealth measures.
Tucker, who’s now a fellow at the Harvard Kennedy School, said the idea deserves consideration, though the impact would need careful scrutiny. “It really matters whether it’s a tax on banking intermediation,” which would be passed on to customers and the wider economy, “or withdrawing a lovely transfer to bankers and equity holders,” he said.
The Fed could end up paying banks around $150 billion in interest on reserves this year, based on current balances and where rates are headed. For the European Central Bank, Ducrozet and his Pictet colleagues Thomas Costberg and Nadia Gharbi estimate payments will amount to at least 93 billion euros, and maybe more if the ECB hikes to 4%.
Read More: Euro Area Braces for Era of Central-Bank Losses After QE Binge
And in a December report, they flagged what may become a political problem, in Europe and beyond: “It doesn’t look good for a central bank to be seen transferring large amounts of money to the banking sector in the middle of an economic crisis.”
More stories like this are available on bloomberg.com
©2023 Bloomberg L.P.