As the UK faces mounting fiscal pressures and seeks more efficient use of public funds, the debate over interest payments on central bank reserves has come to the forefront. This article examines Reform UK’s bold proposal to eliminate these payments and explores the concept of tiered interest rates as a viable solution.
Reform UK has proposed a significant policy change aimed at scrapping the interest payments on central bank reserve accounts. This policy targets the current mechanism where the Bank of England (BoE) pays a substantial interest rate of 5.25% on the reserves held by commercial banks. These reserves, amounting to hundreds of billions of pounds, were created as part of the BoE’s quantitative easing (QE) programs initiated in response to the 2008 financial crisis and the COVID-19 pandemic.
Under QE, the BoE purchased £875 billion in government bonds, injecting liquidity into the financial system. The purchase was funded by creating central bank reserves on which the BoE now pays interest at its main policy rate. Reform UK’s proposal seeks to eliminate these interest payments, arguing that they constitute an unnecessary fiscal burden on the government, enriching banks at the taxpayers’ expense.
The primary economic rationale behind this proposal is to reduce the fiscal burden on the government. By stopping the interest payments on these reserves, the government could save a significant amount of money. According to estimates by Capital Economics, halting these payments could save up to £40 billion annually. Even with the expectation that interest rates may fall and the BoE may sell more of its QE bonds, the savings are still projected to be substantial, likely around £17 billion per year.
These savings could be reallocated to other pressing needs, such as funding public services, reducing the tax burden on citizens, or investing in infrastructure. The current policy is seen by Reform UK and other critics as an inefficient use of public funds. Professor and economic commentator Richard Murphy has estimated that banks are profiting by more than £35 billion annually from these interest payments, money which could otherwise be used for public benefit.
The proposal by Reform UK comes at a time when the UK is facing significant fiscal challenges. The Conservative and Labour parties have both ruled out raising major taxes, such as income tax, national insurance, and value-added tax. This leaves a gap in funding public services without increasing the national debt.
Instead of using the policy to shore up government finances, Reform UK hope to slash taxes by £40 billion. This substantial reduction is intended to provide immediate financial relief to taxpayers and inject a significant stimulus into the economy. The cornerstone of this tax cut is a dramatic increase in the income tax threshold. Under the current system, individuals start paying income tax at an annual income of £12,570. The Reform UK plan proposes raising this threshold to £20,000, allowing individuals to retain a larger portion of their earnings.
Background on Interest Payments on Reserves
Central bank reserves are a crucial part of the banking system, serving several essential functions. They help banks meet their day-to-day payment obligations and regulatory requirements. More importantly, they play a vital role in the implementation of monetary policy, allowing central banks to influence short-term interest rates and liquidity in the financial system.
Historically, central banks did not pay interest on reserves. This changed in response to evolving economic conditions and monetary policy strategies. In the UK, the Bank of England did not pay interest on reserves before the financial crisis. The decision to start paying interest on reserves was influenced by a desire to improve monetary policy implementation and to ensure that banks held sufficient reserves to meet their obligations without incurring opportunity costs.
The massive injection of liquidity through QE was aimed at lowering interest rates, encouraging borrowing and investment, and supporting economic recovery. However, the creation of these reserves also led to significant amounts of money being held by commercial banks in their central bank reserve accounts.
Under the current policy, the Bank of England pays interest on the reserves held by commercial banks. As of now, this interest rate is set at 5.25%, the Bank’s main policy rate. The rationale behind this policy is to control the short-term interest rates and ensure that banks have the necessary liquidity to operate smoothly. However, this policy has substantial financial implications for the government.
The cost of paying interest on these large reserves is significant. Some estimates suggest the cost could exceed £40bn for the whole of the financial sector. This substantial expenditure represents a significant fiscal burden, contributing to the government’s overall budgetary constraints.
The Issue with Interest Payments on Reserves
The policy of paying interest on central bank reserves has come under significant scrutiny for several reasons. Critics argue that it primarily serves to enrich commercial banks at the expense of the public.
Banks receive substantial interest payments that boost their profits without corresponding contributions to the broader economy. The fact that these reserves were essentially “gifted” to the banks as part of the quantitative easing program further fuels the argument that the policy is inequitable and misaligned with public interests.
From a fiscal perspective, paying high interest on these reserves is seen as inefficient use of public funds. The government incurs significant costs in making these payments, which could otherwise be allocated to pressing public needs. Public money is being used to generate risk-free returns for banks rather than being invested in areas that could benefit the wider population.
The financial resources used to pay interest on reserves could otherwise be directed towards funding public services. This diversion of funds exacerbates the pressures on public services, which have faced cuts and underfunding in recent years. Favouring financial institutions in this manner, at a time when public services are underprovided, and the tax burden remains high, seems like an incredible misallocation of resources.
There are however strong counterarguments from the Bank of England and the financial sector regarding the proposed policy change. Bank of England Governor Andrew Bailey has expressed concerns that limiting interest payments on reserves could impair the central bank’s ability to manage the economy through interest rate changes. He argues that paying interest on reserves is crucial for maintaining control over short-term interest rates and ensuring effective monetary policy transmission.
Chancellor Jeremy Hunt has also cautioned that such a move could harm the UK’s competitiveness as a financial services centre. The concern is that reducing interest payments on reserves might deter banks from holding reserves at the central bank, potentially leading to liquidity issues and reducing the overall attractiveness of the UK as a financial hub.
Tiered Interest Rates
One potential solution to the issues of Reform’s proposal is to implement a tiered interest rate, that apply different interest rates to different portions of bank reserves. Instead of paying a uniform interest rate on all reserves held at the central bank, a tiered system pays the full policy rate on a portion of the reserves and a lower or zero interest rate on the remainder. This system can balance the need to control short-term interest rates while reducing the fiscal cost of interest payments on large reserve balances.
The ECB has implemented a tiered system where a portion of banks’ excess reserves earns the full deposit facility rate, while the remaining reserves earn a lower rate or zero interest. The BoJ also uses a tiered interest rate system as part of its monetary policy framework. Under this system, reserves are divided into three tiers, with the highest tier earning the full interest rate, the middle tier earning a reduced rate, and the lowest tier earning no interest. This tiered structure helps these central banks to ensure liquidity in the financial system without excessive fiscal costs
Implementing a tiered interest rate system could result in substantial fiscal savings. It is estimated that such a system could save up to £30 billion annually. By paying the full policy rate on only a portion of the reserves, the government could reduce the overall cost of interest payments, freeing up significant resources for other public expenditures such as healthcare, education, and infrastructure. Alternatively, it can go towards lowering the tax burden which would contribute to easing the cost of living.
The experience of other central banks, such as the ECB and BoJ, shows that tiered interest rates can effectively maintain monetary policy control. By paying the full policy rate on a strategic portion of reserves, the central bank can continue to influence short-term rates while reducing the overall interest burden. This approach has proven effective in other economies, indicating that the Bank of England could adopt a similar system without compromising its monetary policy objectives.
If the BoE stop paying interest on excess reserves, banks will naturally seek to avoid holding excess reserves by shifting funds into more profitable investments. This behaviour could undermining the BoE’s ability to control short-term interest rates. By raising reserve requirements, banks can be mandated to hold a larger portion of their deposits as reserves, thereby reducing the excess reserves available for such profit-seeking manoeuvres. This will ensure that banks maintain necessary liquidity and stability within the financial system, while allowing the BoE to retain effective control over monetary policy without the need to excessively incentivise reserve holdings through interest payments.
In light of the significant fiscal challenges and the pressing need for more efficient use of public funds, the case for adopting tiered interest rates on central bank reserves is compelling. Reform UK’s proposal to scrap uniform interest payments highlights the substantial fiscal burden these payments impose, diverting resources from critical public services and contributing to austerity. By transitioning to a tiered interest rate system, the Bank of England can maintain effective monetary policy control while achieving considerable cost savings. The successful implementation of such systems by the European Central Bank and the Bank of Japan demonstrates that tiered rates can balance the need for liquidity and stability with fiscal responsibility. Implementing this change in the UK would not only align monetary policy with public interest but also provide a much-needed boost to the economy by reallocating funds to essential services. As the UK navigates its economic future, adopting tiered interest rates represents a pragmatic and equitable solution to enhancing fiscal sustainability and promoting economic well-being.