Market notice
During the course of 2022, the Monetary Policy Committee (MPC) began reducing the stock of assets held in the Asset Purchase Facility (APF) to meet its monetary policy objective. On 3 February, the MPC voted to cease reinvestment of maturing gilts and corporate bonds, and asked Bank staff to design a programme to sell the APF’s holdings of corporate bonds to be completed no earlier than towards the end of 2023. At its May meeting, the MPC asked the Bank of England (the Bank) to develop a strategy for selling UK government bonds (gilts) held in the APF and committed to providing an update at its August meeting. Having reviewed that strategy, in August the MPC announced it was provisionally minded to commence gilt sales shortly after its September policy meeting, subject to economic and market conditions being judged appropriate and subject to a confirmatory vote at that meeting.
The monetary policy judgments underpinning these decisions are set out in the relevant MPC minutesfootnote [1] and Monetary Policy Reports.footnote [2] This Explanatory Note summarises the implications of the MPC’s decisions in three key areas: (1) the mechanics of APF asset sales; (2) ensuring short-term market interest rates remain close to Bank Rate, including via the prospective launch of a new Short-Term Repo facility; and (3) the longer-term asset composition of the Bank of England’s own balance sheet.
1: The mechanics of APF asset sales
The Bank has today published a Market Notice providing an overview of how it expects to implement APF gilt sales, which would be operationalised following a confirmatory vote by the MPC. It covers: the Bank’s approach to designing a gilt sales plan; liaison with the Debt Management Office (DMO); key operational terms; and details of additional information that the Bank will require Gilt-edged Market Makers to submit on end-client participation. Further detail will be published on or around 1 September, followed by confirmation of a specific auction schedule at the point of any MPC vote to commence gilt sales.
A high-level Market Notice relating to the sale of corporate bonds held in the APF was published in May of this year, and operational details of the Bank’s plan for sales will be set out in a further Market Notice to be published on 18 August (one month ahead of the start of sales in the week commencing 19 September).
2: Keeping short-term market interest rates close to Bank Rate: a new Short-Term Repo facility
The Bank’s balance sheet is used to implement the MPC’s decisions in order to meet the inflation target. Once the MPC makes a decision, Bank staff implement that policy. A core objective of the Bank's approach to implementing monetary policy is to keep short-term market interest rates close to Bank Rate.
The Bank transmits Bank Rate to short-term market interest rates via the remuneration and supply of central bank liabilities (known as ‘reserves’) held by commercial banks. Reserves are remunerated at Bank Rate. They can be supplied in a variety of ways, but funding asset purchases by the APF has been by far the dominant source of reserves creation in recent years. This has left the stock of reserves well above the level required by commercial banks to meet their payments obligations and broader liquidity needs. The ample supply of reserves has ensured that commercial banks have had little need to bid up money market rates above Bank Rate to borrow reserves. At the same time, remuneration of reserves at Bank Rate has meant that banks have had no incentive to lend excess reserves at rates below Bank Rate. Taken together, this so-called ‘floor system’ has kept short-term interest rates very close to Bank Rate.
A reduction in the size of the APF has implications for the operation of this system. As assets held in the APF mature, or are sold back to the market, the reserves used to fund those purchases will be extinguished. Indeed, reserves have already fallen by £30bn to around £950bn since 4 February 2022, as assets held in the APF have matured. Reserves may also fall for other reasons, most notably via the repayment of loans made under the Bank’s Term Funding Scheme with additional incentives for small medium-sized enterprises (TFSME).
While reserves remain in ample supply relative to the needs of commercial banks, the floor system will continue to operate smoothly. But as APF unwind continues, the stock of reserves will eventually approach the minimum level needed by banks. At that point, banks are likely to respond by seeking to borrow reserves in money markets, increasing the rates they are willing to pay to do so and thereby causing short-term interest rates to rise relative to Bank Rate. If no other actions are taken, this would impair the transmission of monetary policy to the wider economy (see Chart 1).
Chart 1: Relationship between market rates and Bank Rate as reserves decline
As Section 3 below explains, the point at which reserves become scarce in this way is probably several years away, given the MPC’s initial pace of APF unwind. But commercial banks’ overall demand for reserves is highly uncertain. It will evolve in response to financial and economic conditions, and may also be influenced by the distribution of reserves across the system, or other features of market structure. It is therefore possible that reserves scarcity could arise much sooner than expected.
To ensure that short-term market rates remain close to Bank Rate whenever that point is reached, the Bank will launch a new open market operation, the Short-Term Repo (STR), at the same time that APF gilt sales begin. The facility will allow counterparties to borrow unlimited amounts of reserves for 7 days, against high quality Level A collateral, at Bank Rate. A Market Notice has been published today describing the facility’s key terms.
The STR will allow the MPC to focus solely on monetary policy considerations in setting its strategy for APF unwind, without concern for the Bank’s ability to align short-term market interest rates close to Bank Rate. Without the STR, in order to maintain control of short-term market interest rates the MPC would have to reconsider APF unwind at the point that upwards pressure on market rates began to appear, whether or not that was optimal from a monetary policy perspective.
Chart 2 illustrates how this will work in practice. At the point that reserves reach the minimum desired level, banks will be able to meet their demand for reserves at Bank Rate through use of the STR. This will stabilise the quantity of reserves supplied to banks, while allowing the MPC to continue reducing the stock of assets held in the APF.
Chart 2. Stylised supply of reserves during the APF unwind
This framework will also allow the Bank to retain the flexibility to expand or contract its balance sheet as needed to achieve its statutory policy objectives, while maintaining control of short-term interest rates. By both supplying and remunerating reserves at Bank Rate, the framework will ensure that commercial banks have little need to pay up in money markets for reserves (since they can borrow additional reserves from the STR at Bank Rate) or to lend excess reserves below Bank Rate (since they can earn Bank Rate by holding reserves at the Bank).
The intention is for the STR to be a weekly facility. It will complement the Bank’s other reserve supply operations including the Indexed Long-Term Repo (ILTR), which supplies reserves for six-months at a price related to demand, against a much wider range of collateral types than is envisaged for the STR.
The Bank intends that the STR should be used freely from the point of introduction, as a way for counterparties to access reserves as necessary. The PRA would judge use of the STR as routine participation in sterling money markets and intends that it should be seen as such by bank boards and overseas regulators.
3: Evaluating the longer term asset composition of the Bank of England’s own balance sheet
Under this new framework, the eventual future steady state size of the Bank’s balance sheet will be determined not by the size of the APF but by commercial banks’ demand for reserves. The Bank’s latest estimate of the minimum level of reserves demanded by banks, based on periodic surveys of banks’ reserves management practices, is somewhat below half the current stock of £950bn. But, as noted in Section 2, that estimate is both highly uncertain, and likely to vary over time in response to financial and economic conditions.
As reserves scarcity approaches and usage of the STR becomes consistently material in scale, the Bank will need to reflect on the appropriate long-term mix of assets on its own balance sheet. In doing so, the Bank will need to consider the implications of different assets for its policy objectives, market functioning, commercial banks’ liquidity positions, operational feasibility, and risks to the public sector balance sheet. The relative merits of the options will require careful evaluation before a final decision can be made. The estimates of the minimum level of reserves demand described above, coupled with the MPC’s initial pace of APF sales, suggest that it is likely to be some years before this decision needs to be finalised. The Bank’s aim would however be to reach a preferred direction of travel, in close consultation with relevant stakeholders, well before that point is reached.