How Gordon Brown could tempt Labour into a stealth ‘mortgage tax’

Gordon Brown and Nigel Farage are not usually political bedfellows.

Yet in an unexpected turn of events, both the former Labour prime minister and the new leader of Reform want the next government to take the same step: slash the money paid by the Bank of England to commercial banks.

A technical change to the way the Bank works could save taxpayers billions – something that looks increasingly attractive as public finances remain tight. Speculation is mounting that Reeves will find the policy simply too tempting to ignore if Labour wins power.

But commercial banks that would lose out from the change warn the policy risks leading to higher mortgage rates – in effect making it a stealth tax on homeowners.

At issue is the way high street lenders earn interest themselves. Commercial banks need a bank – and Threadneedle Street plays that role. It pays the base interest rate on all the cash stored, an important mechanism for transferring monetary policy into the real economy.

The financial burden of this arrangement has risen markedly in the wake of the Bank’s crisis-era money-printing spree, first during the financial crisis and then Covid. It has left commercial banks with far more money to store.

The Bank used the new money it created through quantitative easing (QE), as the money printing was called, to buy bonds.

When the base rate was at rock-bottom, the Bank of England made a profit. It paid little to the commercial banks but received interest on the bonds it had bought. At the peak, in mid-2022, profit totalled almost £124bn, which went to the Treasury.

However, now the base rate is 5.25pc, the Bank is losing a fortune – and the Treasury is on the hook to fill the financial hole.

Last year Jeremy Hunt, the Chancellor, sent £44bn to the Bank of England and forecasts from the Office for Budget Responsibility (OBR) suggest a loss from QE of more than £100bn by 2032.

The Treasury is desperately short of cash and the need to spend tens of billions of pounds to cover QE is making this worse.

Brown and Farage both want to change the way the Bank pays interest in order to save taxpayer money and free up headroom for spending.

Rachel Reeves, Labour’s shadow chancellor, has played down the idea of adopting the policy if she wins the keys to Number 11 Downing Street in next month’s election.

But it is a sorely tempting option for a party that has ruled out increasing income tax, National Insurance contributions and VAT, faces pressure to raise spending, and wants to stick to tight borrowing limits.

Brown last month pointed out that other central banks around the world do not pay interest in the same way.

The European Central Bank (ECB), for instance, pays interest on only a portion of commercial banks’ reserves, in an arrangement known as tiering.

“With interest rates far higher, there is a substantial cost to the public purse, which wouldn’t arise if – as in the past, and as in other parts of the world today – full interest ceased to be payable on reserves,” Brown said.

The former Labour leader has suggested copying the ECB’s approach. His proposal could save the Government more than £3bn.

Meanwhile, the Reform UK manifesto calls for an end to interest payments altogether, saving potentially 10 times as much.

So far Labour has demurred. Reeves last week said: “We have got no plans to do that” – a form of words that falls short of a cast-iron guarantee not to change the interest payments in future.

There are some good reasons to go ahead. Carsten Jung, an economist formerly of the Bank of England and now at the Left-leaning Institute of Public Policy Research, notes that nobody expected this to happen when the Bank started paying interest on reserves in 2006, nor when QE began in 2009.

“The Bank of England’s windfall payments to private banks are an unintended policy accident and they are an outlier internationally,” he says.

The windfall is significant: NatWest last year received almost £3bn in interest on reserves; Lloyds Banking Group got £2.6bn; Santander was paid £1.9bn, with Barclays not far behind. That is £9bn going to just four banks.

Paul Tucker, a former deputy governor of the Bank, argued in an influential 2022 paper that the scale of the payments caused by QE was so large that it disrupted the financing of the Government.

But there is no such a thing as a free lunch and there are reasons to fear that reducing payments to banks could backfire.

Perhaps the most worrying for mortgage-holders is the fact that banks would be unlikely to take the hit lying down.

Lenders would likely try to recoup the lost interest revenue elsewhere, either from paying less to savers or by raising the rates they charge to borrowers.

Jack Meaning, a former Bank of England economist now at Barclays, says different options available could save the Government, and cost the banks, between £1bn and £11bn a year.

To claw £11bn back, banks could add as much as half a percentage point to their mortgage rates.

Figures from industry group UK Finance indicate this would cost a typical fixed-rate mortgage borrower just over £68 extra per month, or £820 per year.

One banking source said any such raid on the interest paid to banks would therefore amount to a stealth “mortgage tax”.

There are other reasons to be wary of shaking up the way the Bank pays interest. Reeves herself gave one last week: “The paying of interest on reserves is part of the transmission mechanism for monetary policy – it is one of the ways that higher interest rates filter through to the real economy, so I don’t think that would be without its dangers.”

Andrew Bailey, the Bank’s Governor, last month defended the interest payments as “an essential anchor for the implementation of monetary policy”. Removing it could undermine the way the Bank seeks to influence the economy.

Swiping the cash could also undermine other parts of the financial system, and potentially any future use of QE in another crisis.

Stephen Millard, previously a Bank of England economist and now at the National Institute of Economic and Social Research, says it would be “really pernicious” to change the rules of the game.

“The result of QE is that banks are effectively forced to hold very large amounts of reserves that they otherwise wouldn’t be holding. It was almost a quid pro quo that because we are forcing you to hold these reserves, we are going to remunerate them,” he says.

Banks’ share prices also risk being hammered by the loss of billions in revenue.

This might not distress the average Labour voter but there would be a knock-on effect for the taxpayer, which still owns more than one-fifth of NatWest.

Jung at the IPPR argues that these pitfalls are “eminently manageable.” He believes that banks would be unlikely to raise mortgage rates in response to any changes because their profits are already high thanks to interest rates and many would fear losing market share.

Still, any calculation of this sort is essentially a game of chicken with commercial banks – one that politicians would be loath to lose.

For now, Reeves insists that Labour has no plans to fiddle with the Bank of England’s system. But with money tight and billions potentially up for grabs, many in the City fear a stealth “mortgage tax” will be back on the table before long if Labour wins power.

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