COLUMN-BoE gilt sales more hassle than they're worth: Mike Dolan

By Mike Dolan

LONDON, Sept 18 (Reuters) - Britain's own peculiar dance with central bank independence centers on whether the Bank of England should stop aggravating government debt servicing costs by halting its active sale of gilts. While the optics may be tricky, ongoing bond sales seem hard to justify.

The BoE's meeting on Thursday will, uncontroversially, keep interest rates on hold. In fact, financial markets don't see it easing again for the rest of the year as it bears down on a 3.8% inflation rate that's the highest in the G7.

But the real headache in the economy right now is rooted in fiscal policy and tight budget rules that leave the government some 20 billion pounds ($27.25 billion) short of its targets, raising concern about more tax rises and spending cuts in November's annual review.

Adding to the migraine are rising long-term borrowing costs, with 30-year gilt yields this year hitting their highest since the 1990s.

Many analysts insist the BoE's three-year plan to trim its balance sheet, so-called quantitative tightening (QT), is making the problem worse. And that's because - unlike its peers - the BoE is actively selling gilts, not just allowing them to mature and roll off.

Last month, the Bank's monetary policy report estimated that three years of QT - which has lopped off more than 300 billion pounds ($1.2 trillion) of gilt holdings - had only added 0.15-0.25 percentage points to UK government borrowing costs.

The report argues that the outsized recent rise in 30-year yields has instead been driven by global ructions in long-dated debt.

Not everyone is convinced of that, however, and the Reuters consensus forecast is for the Bank to announce a reduction in the pace of annual balance sheet reduction to 67 billion pounds, well below the 100 billion pounds seen in each of the two previous years.

But even if that consensus proves correct, it would still mean that the BoE would be selling gilts actively through the coming year. And that may yet prove uncomfortable.

FRAGILE AND STRESSED

Bank of America reckons that keeping the 100 billion target would mean the BoE would need to sell about 33 billion worth of bonds next year. To stop outright sales altogether, the overall QT target would have to be reduced to just under 50 billion pounds.

So if the BoE reduces the annual target to 60 billion pounds, BoA expects, that would still leave some gilt sales in the pipeline. The trick may be to steer those away from the long end of the curve "at a time when it is quite obviously fragile (and) stressed," the strategists wrote.

The number crunch here gets quite complex and guesstimates abound, but one can step back and ask a simple question: why is the Bank selling actively at all?

The BoE would likely argue that the impact of these sales is modest, and it may also note that there's an imperative to get the balance sheet down to a more manageable state, largely to create more space to expand it again if needed in future emergencies.

It's good to remember that BoE bond buying over the past 17 years was mainly in response to a banking crash, a vote to leave the European Union, a pandemic, and a gilts crisis in 2022. Balance sheet expansion is clearly now part of the crisis-fighting toolkit and who knows what the future holds.

CHASING ITS TAIL?

As to how much more QT is needed, surveys show that bank reserves boosted by the bond buying remain about 100 billion pounds above what's considered an optimal 'steady state'. BoE Governor Andrew Bailey has said the decision remains "open".

But does it really make sense for the BoE to get the balance sheet down rapidly just so it can be in a position to build it up again? There's a risk that it ends up with a self-fulfilling prophecy here, as ongoing gilt sales could very well trigger the crisis that would require it to intervene in the market again.

This makes even less sense when considering that, as some estimate, the costs of the UK's QT plan are as much as twice what the BoE estimates.

Christopher Mahon at Columbia Threadneedle has pointed out that the BoE's own estimates of the QT impact on borrowing rates have been rising every year. And he notes that external studies the Bank cited show the cost of QT to British taxpayers could be as high as 60 billion pounds - more than three times what it would be under BoE estimates.

Why not just stop the outright sales and take the same path as other G7 central banks?

One big hurdle to halting sales may be concerns that the BoE would be accused of aiding the government ahead of a politically awkward November budget and thus potentially compromising its 28-year-old independence.

If that's the only reason, it may end up as bad policy that just hastens a point at which it has to firefight again.

A different government and central bank worked closely together to build that balance sheet up in 2020. It may not be outlandish for them to keep close tabs on wider economic and financial stability on the way back down too.

The opinions expressed here are those of the author, a columnist for Reuters

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($1 = 0.7341 pounds)