QE, QT and interest on reserves

 The Bank of England governor has written a very good letter after a reform MP suggested not paying interest on reserves. My thoughts.

1. Paying interest on reserves

a. reserves are accounts held by banks at the Central Bank (CB).  They are an immediate source of liquidity.  they have two purposes

    i. Monetary policy. the CB pays Bank Rate on those reserves overnight.  So they are the base of the pyramid of more long-term interest rates.  As the govneor says 

"Over time, we have been able to demonstrate that this approach reduces interest rate volatility at the short-end of the interest rate curve, and thus improves the efficiency of implementation of monetary policy, with real benefits for the economy as a whole."

    ii. Financial stability.  They are "what are called High Quality Liquid Assets (HQLA). Assets such as gilts and other high-quality debt also qualify as HQLA".  So if a Bank needs cash, it can sell these assets immediately.  Remember: banks lend long and borrow short from depositors.  So they are always potentially needing short term cash if their depositors suddenly want their money.

b. What is the optimal level of reserves? The CB could hold very few, like pre-07.  But that was unstable, so for financial stability reasons, better to have large.  But it's a free country

It follows that the overall level of reserves is driven by our financial stability objective rather than the monetary policy objective. However, it also follows that, as the overall regulatory requirement for banks is set in terms of high-quality liquid assets that can be readily converted into cash if needed, there is no requirement specifically on reserves. So, in steady state banks have choices over the amount of reserves they wish to hold.

c. Thus: what determines the demand for reserves? Or, how can the CB get banks to hold reserves?  Two answers, 

    i. by paying interest. 

    ii. by mandating resserve levels.  But this in effect freezes money so bad for lending.  

d. So the Bank has to pay interest.  And in a competitive banking sector, that interest is passed onto depositors: or, depositors give commercial banks their money after which commerical banks have to decide what to do with it, one of which would be giving it to CBs.  So not paying interest is like a tax on banks which is likely ultimately a tax on depositors.  Fine, but that's a fiscal policy decision.

e. What about QE and QT? This is when the Bank holds more reserves than necessary for the above arrangements.  In the absnce of that, the costs/benefits are neutral.  Why is that?  The Bank pays interest on reserves.  But the Bank owns bonds and so gets interest in.  As Jochn Cochrane says, see link below,  usually long term debt pays more than short term debt, so this works out. 

(f. note a good Blog by John Cochrane on paying reserve interest: a few points he makes

"One reason given is that it would save the government money... In addition, interest on reserves is paid to a lot of foreign banks, and sending foreigners money so they can buy American goods is somehow out of fashion.

One answer: If you think that is a good and reasonable idea, here is a better one: stop paying interest on all Treasury debt. Reserves are just another form of government debt, so why stop there? That will generate $1 trillion per year, not in 10 years or so. And lots of foreigners hold Treasury debt too."

 

2. QE and QT

As the letter says: 

"QE involves a different state of the world, where the central bank buys financial assets, thereby increasing the prices of these assets and reducing their yield. It thus has the effect of flattening the yield curve benefitting those who borrow at long maturities." 

Let's unpack this.  If you look at the vote that the MPC votes on it is the purchase of government bonds (gilts) by the issuance of CB reserves.  That is, it is using reserves which pay a Bank Rate to buy gilts. This is swopping short dated financial assets for longer dated ones. 

As the letter then says

"You have challenged the Bank’s approach to QT and whether it represents value for money. There are two main ways to look at value for money here, and it is important to keep them distinct. One – which fits the Bank’s statutory objectives – is to look at the economic costs and benefits and how they fit the Bank’s two objectives. The other is to look at the cost in terms of cash flow and the public finances, which is outside the Bank’s objectives but something that I recognise is important" 

Then, righly it adds 

" The first test is important but challenging. It requires a full set of alternative economic scenarios going back to 2009 when QE started and modelling what would have been the state of the economy in the absence of QE and QT. We have experienced major economic shocks during this period – the aftermath of the financial crisis, Covid, Ukraine. It is easy to forget the severe problems we faced with these shocks. Although the counterfactual is unknowable with any precision, most estimates indicate that QE provided very significant support to the UK economy, protecting both jobs and tax revenues.

 

"Your focus though is on the second test. Here, it is important to consider cash flows, as you indicate, and moreover the impact on the overall public cash position. While QE was being used as an active policy tool, and interest rates remained low, the cash flow was positive, totalling £124bn that was transferred from the Bank to the Exchequer between 2013 and 2022. Once interest rates increased, the cash flow started to reverse, something the Bank had said since the start would happen. Today the net positive cash flow stands at £34bn, but we expect it to go negative over the remaining lifetime of the policies on this basis of calculation."

Remember too that timing is unimportant, which is why stable and predictable is key

" An important point to bear in mind here is that we ought to expect that the cash flow will over time be the same regardless of whether we sell the assets or hold them to maturity. This is because the price discount on an active sale is simply equal to the present discounted value of the carry cost that would be incurred were the assets held to maturity. The timing of the cashflows, but not their overall size, is affected by whether or not there are active sales. By avoiding disrupting markets, our gradual and predictable approach to QT supports this."

That's the essence of the argument, but it continues with a detail concerning the cash flow, even though this isn't part of the Bank's objectives.

"But this is not the end of the story, though it is the end in most of the accounts of the cash flows expected. An important missing element is that successive UK Governments have issued more long-term debt (gilts) than those of other major economies. The average term of outstanding UK Government debt is around 14 years, compared to around 6-7 years in, for instance, the US, Germany and Canada. The Bank’s policy throughout QE was to buy equal amounts across the maturity distribution of gilts, to ensure that our operations were neutral for the gilt market. This means that the Bank now owns more long-term gilts, something that helps to explain why we are conducting more active sales (as we have a slower path for natural maturities). A consequence is that, with an upward sloping yield curve, we do have larger discounts (and would otherwise have larger carry costs) on our long-dated gilts. This has led some commentators to suggest that the Bank’s QT programme is more expensive than those of other countries

 What does this mean? The Bank bought lots of long dated gilts.  So, the Bank has a stock of lots of low coupon paying long dated gilts, which can only be sold to the market, now that the yield curve has risen, for a very low price i.e. at a losss.  So it looks like the QT programme is "expensive" since there are lots of capital losses.

But there is a counter-argument.  

"Because it issued much more long-term debt than other countries when interest rates were low and QE had flattened the yield curve, the UK gets a longer lasting benefit in the form of lower debt costs.

I must emphasise again that these cash flows are not a part of our objectives, but I recognise that we must, and do, have regard to value for money."

 

Foreign Trade, tariffs, Dollar dominance and some helpful national income identities

 The brilliant Maurice Obstfeld has a very good explainer on  The U.S. Trade Deficit: Myths and Realities, Brookings Conference, March 2025.  Here's some useful national income identities

1. in nominal terms

NX=Y-(C+I+G)

where Y is nominal GDP.  This says NX = total output -(domestic absorption)

Implications 

a. NX might "due" to C that's "too high". but it might be due to I that's "too high" i.e. lots of promising investment projects. 

2. Now, define national income NOT as GDP but as GDP plus "net income from the net internatioal investment position".  Define as well national saving as national income (NOT GDP), less consumption.   Thus National income  = Savings S minus I =

Y+(RA-1)A-(RL-1)L 

where A denotes gross claims on foreigners (including banking claims, debt and equity securities, and direct investments) offering a gross interest and dividend yield (that is, not including capital gains) of  𝑅𝑅𝐴𝐴 and L gross liabilities to foreigners offering the yield 𝑅𝑅𝐿𝐿 to nonresident holders. 

Then the current account is 

CA balance=NX +(RA-1)A-(RL-1)L =S-I

3.  Now, let's drill into those returns.  National accounts does not include capital gains on assets as productive activity.  Thus the returns above are excluding capital gains.  Define then  total gross returns 𝑅𝑅~𝐴𝐴 ≡ 𝑅𝑅𝐴𝐴 + 𝐶𝐶𝐺𝐺𝐴𝐴 and 𝑅𝑅~𝐿𝐿 ≡ 𝑅𝑅𝐿𝐿 +𝐶𝐶𝐺𝐺𝐿𝐿.

Then we have 

 Then equation (2) implies that the level of net external assets A − 𝐿, also referred to as the net international investment position (NIIP), follows the process 𝐶 

A𝑡+1 −𝐿t+1 = 𝑁𝑋𝑡 +𝑅A~𝑡𝐴𝑡 −𝑅L�𝑡 𝐿𝑡.

which can be written 

4. what about "exorbitant privilege"? This is when a country can pay less out on its external liabilities i.e. what it owes to the world, than it earns on its external assets i.e. what it earns from the world which is R~L<R~A.  So the last term is positive which means that even with an unchanging A-L, the net exports can be negative. 

From that we have

1. An exchange rate depreciation that lowers M (imports) has to have something else change. It might be that X simply falls too (this is the Lerner point in a non-monetary economy, with M less to try to encorage more Y, then  X has to fall to get resources into domestic output Y). in a monetary economy, tariff means expansion of domestic demand, but interest rates rise, raising the ER until Y back to its former level.

2. The China "shock" was a shock rise in China imports. But since other countries could switch to China it was also a fall in US exports.

3. It is argued "that the U.S. dollar is the world’s overwhelmingly dominant reserve, invoicing, vehicle, anchor, and funding currency....One [theory] asserts that countries can gain the dollar reserves they wish to hold only by running external surpluses with the United States. In turn, as the world economy grows, growing reserve demand obliges the United States to run persistent deficits. A second class of theories focuses on asset-price effects that contribute to U.S. deficits. One of these contends that global dollar demand causes a chronically overvalued dollar. A related claim is that the dollar’s status allows the United States to borrow more cheaply abroad, creating a structural deficit."

Obstfeld says: The idea that the global demand for dollar assets can be satisfied only through U.S. current account deficits is widespread but wrong. The world could alternatively acquire those dollar assets in exchange for other assets rather than goods and services.  

Further "Stephen Miran has set out a “blueprint for restructuring the global trading system” built on a central premise that the dollar’s status will inevitably lead to growing and ultimately unsustainable current account and trade deficits. He calls this a “Triffin dilemma”".

It turns out that US reserves as a share of USGDP are falling not rising. 

Also, says Obsfelt " Moreover, the dollar’s global role – which confers aggregate gains on the United States – derives not only from preferences and needs that foreigners impose on a passive America, but from institutions of U.S. origin (such as a consistent rule of law, independent monetary policy, and deep, open financial markets) that also underpin American prosperity.  "

Even more chain drift

 I hadn't realised until now that the Johnson review has a nice box on Chain drift.

Here's the idea. 

1. Suppose the item 1 is detergent

2. "The price of item 1 halves between periods 1 and 2, causing a big jump in sales. The product returns to its original price in period 3 and sales go back to original share"

3. Good 2 remains same price

4. "Most people would agree that the price index in period 1 should be the same as period 4; after all, the price and quantity sold of both products is the same."

5. And the Laspeyes index delivers that.

6. here's teh problem. the chained index is "calculates overall price change between each pair of periods in sequence and then multiplies them together. So the chained price index in period 4 is obtained by multiplying the price changes in periods 1-2, 2-3 and 3-4 together. 

7. As you can see, the chained index does NOT return to its original value. 

    a. in the chained Laspeyres index, chain drift arises because the product 1 price fall between periods 1 and 2 has low weight (only 10 of product 1 were bought), while the increase to period 3 has high weight (5,000 products). 

b. In the chained Törnqvist index, the average expenditure share (which is what matters in the Törnqvist) is larger in periods 1 and 2 when the price is falling, than when the price recovers between periods 2 and 3. 

Here's some working: this is a problem for scanner data.

Some maths of public spending and labour costs

 From the IFS and my interpretation: 

"Staff costs account for almost half of departmental day-to-day spending.."

"At this Spending Review, departments’ day-to-day budgets are set to grow by an average of 1.2% per year in real terms between 2025–26 and 2028–29."

Assume then that non-wage costs are rising evenly, then 1.2/2=0.6%pa is "available" for real wage rises. 

"The OBR’s March 2025 forecast suggests that total employment is set to grow by an average of 0.6% each year over the same period: one scenario would be for public sector employment to grow in line with this average..."

Thus real wages can grow at 1.2/2 -0.6= 0. 

"This would keep real-terms pay roughly constant (..if inflation is 2.0% per year) ). But these pay awards would be below the OBR’s forecast for average annual economy-wide earnings growth over this period (2.2% in cash terms) and below the pay awards recently announced for 2025–26 (which were around 4% on average). "  

Slow productivity growth: lessons from the past

 I am late to this, but this article by the brilliant economic historian Joel Mokyr is fantastic. "(2018), ‘The Past and Future of Innovation: Some Lessons from Economic History’, Explorations in Economic History, 69, 13–26". https://doi.org/10.1016/j.eeh.2018.03.003 

My notes.

1. What are the lessons from economic history to understand current slow growth?
2. It might be that slow TFP growth is the wrong metric for economic transformation.  "To put it differently, students of contemporary technological progress should wean themselves of TFP-fetishism; aggregate measures such as GDP (the basis for TFP calculations) were designed for a wheat-and-steel economy, not for an information and mass-customization economy in which the service economy accounts for 70–80% of value added." 
3. Three reasons why economic growth was so slow before the industrial revolution
1. Malthusian dynamics
2. Smithian pre-1750 economic growth: "growth based on gains from trade and factor mobility, better-functioning and more integrated markets, and improved allocations due to better institutions. Most of the rise of richer regions and towns in medieval and early modern Europe can be attributed to the widening of local trade and the opening of long-distance commerce.  This was vulnerable to rent-seeking: taxes, confiscation, debt reneging"
3. The third factor that explains slow economic growth before the Industrial Revolution is the most obvious and the least discussed one, namely the simple but undeniable fact that people did not know enough about the physical world around them. 
4. Mokyr discusses more of this in the rest of the paper
1. But as I have noted elsewhere, the pre-Industrial Revolution world was limited in its ability to exploit technological advances because even though the pre-1750 world produced, and often produced well. Inventions in the pre-1700 era, however, were normally the result of serendipitous strokes of luck, flashes of brilliant intuition learning by doing, and the slow accumulation of incremental improvements of techniques in use. It was “a world of engineering without mechanics, iron-making without metallurgy, farming without soil science, mining without geology, water-power without hydraulics, dye-making without organic chemistry, and medical practice without microbiology and immunology "
2. of course, not all breakthroughs needed science. Stephenson invented the Rocket with no science training.  So scicence and tinkering were complements. 
3. The breakthrough was 
1. Scientific understanding 
2. measurement
5. what about the incentives to do science?  Essentially it needs a check on rent-seeking
1. "Mercantilism, as Ekelund and Tollison (1981) have pointed out, was a system of rent-seeking, in which resources were redistributed from some groups to others. Mercantilism came under attack from Enlightenment philosophers, and after 1815 it went into a tailspin, replaced by liberalism and a political economy that regarded free trade, open access markets, and a professional and honest civil service as desirable and just."
2. with trade mobiliy and openness "much faster than in the seventeenth century, in the twenty-first century if an idea is generated somewhere , it becomes available everywhere."
6. Measurement. 
1. "If the variety of products and services is introduced on top of the quality improvement, it seems intuitively plausible that mismeasurement has worsened in the past two decades.
2. It also seems likely that the twenty-first century productivity slow-down described by Gordon is temporary, until new Gen- eral Purpose Technologies such artificial intelligence (AI) and genetic editing have fully been incorporated into production lines
3. Moreover, the productivity gains from technological progress in the past two centuries may have been overstated because of inputs that were used and never paid for, in large part because there were no property rights and markets for those inputs. Of those, the physical environment was clearly by far the largest.
4. In many areas, technological progress should thus be seen as a constantly self-correcting process, in which new techniques have unforeseen negative consequences, which require further tweaking, but those fixes in turn will cause more bite-back effects and so on. What negative bite-back effects mean is that the true social costs of many innovations have been understated and the bill for some inputs will be paid by a future generation. If output is generated at time t while the inputs are paid for in t + 1, any comparison of TFP between t and t + 1 will be confounded. TFP growth in the past has been overstated and so its decline may be exaggerated as well, although it is not known by how much. Some portion of innovative effort in the coming decades, rather than aimed at directly raising living standards, may be directed toward maintaining what we already have and correcting the eventual costs incurred as belated bite-back effects kick in."
5. Here is a good example "Such innovations will contribute to economic output and will thus contribute to measured economic growth. But they may not show up necessarily as TFP growth. To see this, consider the following: suppose we have a fossil-burning power plant that produces electricity at, say, 15 ¢per KwH (which is about the US average). Now suppose that we scrap that plant for environmental reasons and replace it with a windmill farm that, with fixed capital amortized in the same way as the fossil plan, can produce electricity at 15.5 ¢per KwH. Using standard calculations (and relying on the dual of TFP computation), this would imply a decline in TFP as conventionally measured of about 3%. But if the windfarm has zero impact on global temperatures, it will have saved on a social cost that is not counted in the standard national accounts."
7. The impact of computers on science has gone much beyond large-scale calculations and standard statistical analysis: a new era of data-science has arrived, in which models are replaced by powerful mega-data-crunching machines, that detect patterns that human minds could not have dreamed up and cannot fathom. Such deep learning models engage in data-mining using artificial neural networks. "
8.