Interest on reserves —fallacy and fact

The UK’s Reform Party says that the Bank of England should not pay interest on reserves, potentially saving £30 billion a year. The BoE resists it. Which is right?

Richard Tice, Reform’s Deputy Leader accused the Bank of England of enriching City institutions to the tune of billions of pounds at the taxpayers’ expense. But this is typical political-speak, designed to appeal to the masses with a simple argument. Naturally perhaps, The Bank of England has rejected Tice’s proposal.

This was not an issue until the BoE, under pressure from the government of the day and the actions of its central bank group-thinking peers, started to buy up its government’s bonds in the market — otherwise known as quantitative easing (QE).

The objective was to stimulate the economy by creating extra credit. The way QE worked was that pension funds and insurance companies holding gilts would be offered attractive bids for their holdings to encourage them to sell. Those which sold would then reinvest the proceeds, created out of nothing, into other bonds or equities to offer them a better return over the whole transaction.

Because these non-bank institutions do not have accounts with the BoE, the transactions are handled through their commercial banks. Therefore, payment for the QE bonds is credited to the selling institution’s bank. And the selling institution’s bank account is credited to match.

The key to understanding the transaction is that the BoE operates in the same way as any commercial bank. In return for delivery of the QE bonds, the BoE enters into a credit obligation in favour of the pension fund’s banker, on which interest is paid just as if it was a transaction between two commercial banks.

What would happen if the BoE didn’t pay the prevailing rate of interest, as Tice demanded?