Executive Summary

This episode of Macro Matters focuses on the Federal Reserve's balance sheet task force, one of five task forces announced by Chair Warsh to review the conduct of monetary policy. Patricia Zobel, Head of Macroeconomic Research and Market Strategy at Guggenheim Investments and former Deputy SOMA Manager at the New York Fed, joins Matt Luzzetti and Matt Raskin to discuss the balance sheet's crucial role in monetary policy and financial stability. The conversation delves into Chair Warsh's criticisms of the Fed's past balance sheet usage, potential changes to asset purchases (QE), the ample reserves operating framework, the balance sheet's size and composition, and the likely impact of the task force's recommendations.

Cleaned & Structured Transcript

Introduction and Background on the Fed's Balance Sheet

[00:00:15] Matthew Luzzetti: Welcome. You are listening to another episode of Macro Matters on Podzept, a series where we discuss some of the best ideas coming out of Deutsche Bank Research. I'm Matt Luzzetti, Chief US Economist, and I'm once again joined by Matt Raskin, US Head of Rates Research. Welcome again, Matt.

Matthew Raskin: Thanks, Matt. Always fun to do this. So Matt, we have been producing a series of notes on the five Fed task forces that Chairman Warsh announced at the June FOMC meeting. We've been sort of outlining considerations that we think the task forces might take up and our expectations for where things might ultimately land. We've also planned to devote one of these podcast episodes to each of those task forces and bring in experts to talk through the issues. Today we will be focusing on the Fed balance sheet task force and what changes to the balance sheet and balance sheet policy could ultimately result from that. We published a note on that topic about a month or so ago. And for this, we're really excited to be joined today by Patricia Zobel. Patricia is Head of Macroeconomic Research and Market Strategy at Guggenheim Investments, where she leads a team of economists and strategists who inform the firm's macroeconomic and asset allocation views. Before joining Guggenheim, Patricia had a long and storied career at the New York Fed, where among other things, she served as Deputy SOMA Manager and then Acting SOMA Manager. So in that capacity, she managed the Fed's bond portfolio and led the implementation of monetary policy at the direction of the FOMC. So she's really a perfect guest for the discussion we're going to have today. So welcome, Patricia. Thank you so much for joining us today.

Patricia Zobel: Thank you for having me. I'm looking forward to this discussion.

Matthew Luzzetti: Yeah, thanks. It's great to have you. So I think we'll kick off. We've been structuring this conversation, maybe first some background issues around the balance sheet, then maybe digging into some of the specifics around changes that we might get, and then maybe concluding with some details around the task forces and what they might agree to. But just to kick off, why is there a task force on the balance sheet? Why are we talking about the balance sheet? Why does the balance sheet matter? And really, what role does it play in monetary policy?

Patricia Zobel: [00:02:27] So I mean, I think it's important to start from the basics, which is the balance sheet is a really central tool for the FOMC. It's how they set monetary policy and support financial stability. So it's a key element of their policy setting process. In normal times, the balance sheet provides liquid assets to the financial system in the form of Fed liabilities. Some people term this as the plumbing of the system. But it also supports really important US goals. So I think the term plumbing is a little bit narrow for how I think of these liabilities. They implement the stance of rate policy. They help Treasury meet payments, and they keep the payment system itself safe, and these support trust in the US dollar. So that's in normal times. In stressed times, the balance sheet also helps support financial stability. Unlike private sector participants, the Fed's balance sheet is not constrained. So in times of stress, it can provide an elastic currency. And that helps reduce the impact of financial disturbances on the economy. And this was really one of the founding reasons why the Fed was established, was providing an elastic currency. Asset purchases are also used in times of stress to lower long-term rates and help people stay employed in crisis times. What I would say is the balance sheet is not the only tool that the FOMC has at its disposal. They have monetary policy strategy, and clear communications help support the transmission of policy. Bank supervision and payments underpin financial stability. But maybe I'm biased, I think the balance sheet is pretty important.

Chair Warsh's Objections and FOMC Consensus

[00:04:18] Matthew Luzzetti: Yeah, so you've kind of outlined how important it is. Maybe how it's changed a little bit in the past 15 or 16 years since the global financial crisis. At the same time, I think we've seen from Chair Warsh, over time he's been, I think, very critical of some of the Fed's usage of the balance sheets, how it's transformed over the years. Some of the items that I've highlighted from his own speeches were speaking about the balance sheet having a disproportionate impact on inequality, that it might blur the line between fiscal and monetary policies when you talk about things like QE, maybe that with a larger Fed footprint, it distorts market signals. It might be difficult to calibrate relative to the policy rules. So these are the types of criticisms that I think Chair Warsh is coming to these task forces with and the considerations around the balance sheet. How do you think about these core objections that we hear from the new Chair? And maybe also, do you think others on the FOMC might share some of those objections?

Patricia Zobel: [00:05:17] So my sense is I think that captures it well, that he really sees the balance sheet as importantly blurring distinctions between monetary and fiscal policy and that that's an important critique of his. My own sense is, you know, underlying this, there are some issues that are important to discuss. And so I think it's a good time for a task force and for us to elucidate some of those issues. My sense is the FOMC probably wouldn't agree with some of the amplitude of his critiques. I think most importantly, they see themselves as focused on monetary policy, and they see their policies as aimed toward meeting their dual mandate goals of keeping people employed, and that's something that should broadly benefit the American public. But I do think there are places where they can find real common ground on balance sheet issues. And I think my sense is as the task force moves forward, that's where we'll be focused. So for active balance sheet policies, my sense is the FOMC continues to be supportive of this as a tool in times of crisis, as I said, or in deep downturns. This supports their dual mandate. And to some extent, Warsh agrees with that. He has said on several occasions that balance sheet actions are necessary during crisis. So when you think about it at its core, his critique is primarily around calibration and duration of use, not so much the tool itself. And I think the FOMC would be open to considering the evidence on calibration and design. Although they may differ in degrees, I think there's a conversation to be had there.

[00:07:03] Right now, a lot of the discussion isn't really about crisis measures. The task force is pretty focused on the steady-state balance sheet. I think still Chair Warsh thinks that the current size of the balance sheet blurs distinction between fiscal and monetary policy and interferes with the monetary policy stance. My sense is that the FOMC may see that cost-benefit a little bit differently. In terms of liabilities, I think they see these as playing important roles and they should be supplied as demanded. And several FOMC participants have recently come out with that kind of view. So I think they would be open to lowering the demand for reserves, but not measures that would force demand lower because they see the benefits of those. In terms of the cost to the current balance sheet size, I'm not sure they see the same degree of interference with monetary policy or interaction with fiscal policy. The balance sheet is down 30% from its peak. So pandemic stimulus has been largely reduced. And I'm not sure they see a lot of fiscal interaction at this point. I think it's interesting to note that the SOMA Treasury holdings are roughly about the same size of the Treasury universe as they were pre-GFC, and that's because Treasury securities have grown so strongly and there's some MBS holdings, but I don't see there being more fiscal interference now than in the past. Despite this, them seeing these costs and benefits a little bit differently, I really think there's a path to consensus, a place where they can find agreement, which is reducing demand for reserves by working on some of the things that are holding demand for reserves up and shortening the Treasury portfolio. I think there's where there's, for both, I think there's broad agreement that could be arrived at.

Asset Purchases (QE) as a Monetary Policy Tool

[00:09:07] Matthew Raskin: That's really interesting. So there's so many dimensions of balance sheet policies. I think you nicely outlined at the start that the task force could take up. And I think that and the very ambitious timeline for its work and for the work of the other task forces make it kind of challenging, I think, to judge the breadth and depth of what they'll ultimately take up. But in the note that we published a month or so ago, we kind of framed the possibilities around four core topics. And we've already touched on these a little bit. The first of those being the use of the balance sheet as a tool for monetary policy. And that's really about asset purchases or what everyone outside the Fed calls QE. The second is the implementation framework, which you were just touching on there, how they control and use the balance sheet and their liabilities to control the Fed funds rate and hit the target that they establish for it. Then there's the size of the balance sheet. And finally, the composition of the balance sheet. And I would argue the last two of those, the size and composition, are to a certain extent downstream of decisions they might make about how they use the balance sheet as a tool of policy and in implementing rate control. So I think if it works, we'll sort of dig into the details around each of those. I think it's probably a good way to frame this discussion. So maybe just starting on use of the balance sheet as a tool for monetary policy. By way of background, I think the Fed has done asset purchases for really two primary purposes. The first being to adjust the stance of policy, ease financial conditions, ultimately achieve the dual mandate objectives. And the second is to support market functioning, the functioning of core fixed income markets like the Treasury or MBS markets. They've also used Quantitative Tightening (QT) or balance sheet runoff over a couple episodes over the last 15 years or so, but done so very differently to the way that they do asset purchases. QT has been passive. It's kind of been operating to a large extent. In the background, they haven't adjusted the pace of balance sheet runoff in response to macroeconomic conditions. But let me just kind of put the open-ended question out there. I mean, what, as we think about the balance sheet as a tool of monetary policy, either to adjust the stance of policy or to support market functioning, how do you think about what changes around that could result from the work of the task force, whether that be when and how they're used, the governance around them, communications around them, their accounting, the whole host of associated issues?

Patricia Zobel: [00:11:40] So first of all, I would like to say, I mean, I think there's really important work to do on asset purchases. I think it's a relatively new tool of policy for central banks in the way that they've been used since the global financial crisis. And so I do think there's important work to think hard about asset purchases and the framework for them. What I find interesting about the task force descriptions is that they didn't explicitly include this in the remit. They talk a lot about re-examining ample reserves in the operating framework. They talk about the composition. It's not explicitly in scope. But my sense is given the focal points of the task force leads, it's going to be considered by them. You know, Rajan in particular has talked about some of the costs of balance sheet expansions. Dinan has been focused on excess stimulus during the pandemic and which may have been the interaction of fiscal and monetary policy. And so my sense is it will be covered.

Matthew Luzzetti: [00:12:48] And Warsh himself, as you go back, was, I think, somewhat critical of QE policies after the first QE.

Patricia Zobel: [00:12:55] Right. And in particular, right after he left the Fed, he was one of his comments was that he didn't want to see QE continued at that juncture. Again, he didn't want to see the duration of it as long as the FOMC had. My sense is coming out of this task force, if I could think about the result is that asset purchases will be maintained as a tool. I think I said that before. They're critical in some environments. I would hesitate to think what might have happened with the GFC or the pandemic if they weren't used at all. I think you would have seen higher and longer lasting unemployment. But it needs to be brought into a framework to ensure two things. One, that it's used judiciously, and that it's designed efficiently and effectively. And I see three things that seem important in this regard.

[00:13:53] First, I think the task force might focus on how asset purchases fit within the monetary policy strategy. The FOMC has been explicit about when asset purchases are used somewhat in the consensus statement, but I think they could go a little further than that. For example, saying they'll be used when policy is materially constrained by the zero lower bound or dysfunction threatens the transmission of policy. I think defining the circumstances is important for accountability about how you would use that tool. So I think that's a start.

[00:14:32] The second thing I would say is that design principles could be developed consistent with asset purchases goals. As you said, market functioning and accommodative purchases are very different. And so market functioning purchases work through flow effects. And so you want to design a program that is flow-based with price-sensitive execution and maybe a shorter holding period. And some of these ideas sprang out of work from the BIS that I know you participated in, and the Bank of England put that into practice during the LDI challenges a couple years ago. And I think that was effective. On the other hand, accommodative purchases work through duration channels and support policy communications. And in that instance, you probably want long duration purchases, stock-based announcements, and maybe longer holding periods. And I think designing them differently will have important benefits for how effective and how efficiently they're used. And then I would say finally, clear communications. I mean, I think it's important to communicate clearly with the public the different frameworks that you're using for these purchases and provide transparent transition points between, let's say, market functioning purchases and accommodation purchases. And I think that will help.

Matthew Raskin: [00:15:56] That transparent transition point was, I think, noticeably absent, at least in my view, during the COVID QE, because the committee did transition from an initial objective which was focused on supporting and then sustaining market functioning and had a purchase pace of 120 billion per month to meet that objective. And as the objective expanded to include fostering accommodative financial conditions in pursuit of the dual mandate objectives, they continued to purchase the same constellation of assets and in the same amount. And I've always wondered whether that presents issues for them, whether that blending or bleeding of objectives served a particular set of objectives at the time, but is maybe counterproductive as we think about how the tool could be used going forward. How do you think about that?

Patricia Zobel: [00:16:46] So I think it's easy to look back on the pandemic with certainty now. I think at the time, the markets were extraordinarily dysfunctional for a period of time, and it was hard to know maybe when that ended completely. But I think it's fair to say with some lessons learned that a more transparent transition point would have been helpful. In a couple of ways I see. One is that I think after you transition to accommodative purchases, what you can do is purchase long dated securities, drop some of the shorter dated purchases. That will reduce the liquidity impact of what you're doing. It allows you to have a moment to take stock of how much has been purchased, how much additional needs to be purchased. So with hindsight, there probably could be some lessons going forward from that. So I think, for me overall, I think, putting a framework around asset purchases probably helps ensure that the tool is deployed to its best use without some of the, and making sure that you're getting the maximum benefit out of them without some of the costs, which are the potential for excess accommodation, liquidity effects, or losses. And you know when the costs exceed the benefits?

Matthew Luzzetti: [00:18:10] You mentioned, I think I would agree, that it seems like the committee will continue with QE potentially as a policy as you hit the zero lower bound. Do you think MBS purchases will remain part of the toolkit? It seems to be an area of focus. During periods where we're now running down the balance sheet, they run off very slowly. There's maybe an argument to be made that around COVID, you didn't need to provide more accommodation to the housing market for a period of time. So does that part of it, might that change? Might we just see purchases that are more focused on Treasuries?

Patricia Zobel: [00:18:46] Well, it's a great thing to think about. I mean, I think when you think about why MBS were used, when you think back to the global financial crisis, MBS were initially purchased to address stress very specific to the housing market. And they were very effective at quelling those stresses during a time when that stress was emanating out to the economy. So I think they were purchased in LSAP 1. I think there were some added in LSAP 3, but importantly, they weren't used in LSAP 2 or the MEP program in between. So I think that going forward, the FOMC is likely to be judicious in their use of MBS. I think some FOMC participants, particularly Waller, former President George, have mentioned that MBS as a tool of pure QE, not to address housing market finance stresses, may need to be used carefully. And the FOMC in general would like to hold less MBS on their balance sheet. They feel like it interferes with the distribution of credit in the US system. So my sense is it won't be put away completely, but that it will be used judiciously.

Matthew Raskin: [00:20:16] I mean, my sense has always been that, as you know, during the global financial crisis, the stresses were emanating from the housing and mortgage market. There were, I think, good reasons to be purchasing MBS. My sense is since then, a lot of the motivation has been to ensure that they had sufficient capacity, that there was enough for them to purchase without having an adverse impact on liquidity. And they worried that in the amounts that they were doing, that maybe it was too much for the Treasury market alone. And then the moment the MBS are on the balance sheet and they ultimately pivot towards reducing the balance sheet QT, they're very clear that they want to get MBS off the balance sheet and get back to a primarily Treasury portfolio. My sense though is that we're in a world now where, I mean, one, the likelihood of doing, of hitting the zero lower bound and being constrained by it may be lower going forward if indeed the neutral level of the Fed funds rate is higher than it was, which we've been advocating for a while. But also the Treasury market has grown a lot. I wonder, do you think they'd need to, in the event that they were at the zero lower bound and judged that they needed additional stimulus that they looked to provide through asset purchases, do you think they'd need to use MBS?

Patricia Zobel: [00:21:31] So my sense is, the chances that they need to use MBS for accommodative purchases, not to address stress in the housing market, are probably, as you said, much reduced. The Treasury market has grown quite substantially. It's got a lot of capacity for purchases. I think the committee under most circumstances could implement what it needs to, given the size of the Treasury market.

Matthew Luzzetti: [00:21:59] Yeah. So one of the benefits of debt to GDP rising above 100% is that we might not have to go back into MBS purchases, potentially.

Patricia Zobel: [00:22:06] I guess you could frame it.

Matthew Raskin: [00:22:07] Leaves a lot of paper for the Fed to purchase if they ever need to.

Implementation Framework and Balance Sheet Size

[00:22:10] Matthew Luzzetti: But that's maybe one of the upsides. Maybe if we can transition away from kind of thinking about it as a monetary policy tool and maybe some questions around the implementation regime. I guess the first question is, do you think that they stick with the ample reserves regime? And I'm reminded, I think Matt always references this quote from Chair Powell in the transcripts back in 2018 or 2019, I think, when they initially took over with an ample reserve regime where he mentioned that he would have regrets, I think.

Matthew Raskin: [00:22:43] Yeah, I think buyer's remorse was the phrase that he used in, I think it was the December 2018 meeting where they were talking about the amount of reserves they might need to keep in the system to operate an ample reserves regime. And I think he said if it came in meaningfully above 1.5 trillion, he would likely have buyer's remorse. And of course, we're at roughly twice that today.

Matthew Luzzetti: [00:23:03] Yeah, so to me, that's just interesting context. I think there seems to be everybody agrees we're probably going to stick in this ample reserves regime, but maybe there's some officials that have maybe different views on how that might play out. So do you think we end up keeping the ample reserves regime? Do you see any changes being made to that?

Patricia Zobel: [00:23:23] So I think, first of all, in 2018, 19, 1.5 trillion is about where we landed in 2019 when reserves troughed and we began maintaining reserves in the system. And that was somewhere, in the 7% to 8% of bank assets. I think right now we're at around 11% to 12% of bank assets in terms of reserve. So it's not double. It's really you have to think about it in terms of the size of the system. It is a few percentage points higher. But I think one of the, over this time period, I think the committee has gotten more comfortable with how the ample reserve system operates. And my base case is they probably maintain an ample reserve system, but they do try to achieve some of the efficiency that you were speaking about, Matt, that they try to run something that has maybe a little bit lower demand for reserves than we're seeing right now. Their support for ample reserves, I don't think, one could think they're just going to make this decision by default. They're operating it. I really do think it's based on principles. There's benefits in terms of rate control, in terms of financial stability. It allows us to have a Treasury General Account (TGA) that provides liquidity benefits to the Treasury, which you can't do under scarce or other systems. So I think there are principles-based reasons to want to keep an ample reserve system. But there's room for a lot of recommendations that could make it run a little bit more efficiently.

[00:25:02] As President Logan has said, one of the things you might want to do is try and shift the demand curve in. For me, I think there are banks are pretty clear about why they hold reserves through a lot of surveys. They say regulations, mostly the internal liquidity stress test, intraday payments, and discount window avoidance. And so, I would say this means two things in terms of addressing how to make the system more efficient. One, you want to encourage banks to rely a little bit more on Fed backstops for liquidity, both in normal times and in stress planning. If this is successful, it could both reduce reserve demand and make the system more resilient because it has a shock absorber that works. And this is really a win-win. And I think that has a lot of support, both from people who'd like to see a smaller balance sheet and those who are more comfortable supplying liabilities as demanded. So I think that's something that'll be a core focal point. The second one, and this is a hope of mine, is that the task force reflects on how market structure affects the liquidity needs of the system. The US money market system is fragmented. It needs modernization, and that increases the liquidity intensity of the system. You know, some efforts are currently underway. There's clearing efforts. There's intraday repo. Cost-benefit is still being examined of some other things like liquidity savings mechanisms, one thing that Darrell Duffie has recommended. But in addition to those, I really hope the task force peaks around the corner because 24/7 and tokenized payments are coming and they're going to have significant impact on monetary policy implementation. So I really hope they mandate a study opportunity to create an efficient system in the United States and gain some liquidity efficiencies. When you read the studies, there are some to be had with this type of settlement, but you need to have some planning around it.

[00:27:21] A key, one thing I would be watching for in the task force, I'm talking about ways to reduce reserve demand without applying costs on reserves. One thing I would be watching for is if they see large costs to supplying reserves, if they see the same types of costs to the balance sheet size that Chair Warsh does, that would lead them to impose costs on reserves to get reserve demand down. Right now, there's already a small incentive for banks to move out to short and medium-term securities in terms of term premium. But if they see, you know, if you see arguments coming from the task force that the cost of supplying reserves are high, you can anticipate things like tiering of IORB to try and put a cap on the reserve demand. I think that would be more outside of market expectations. The one thing I don't think is going to be considered is truly scarce reserves. You know, that created meaningful payment system risk before the GFC. And so I don't think that's going to be something that they really consider.

Matthew Raskin: [00:28:33] Interesting. Can I ask in terms of the costs of supplying reserves and being on the lookout for whether there's sort of a focus on that, what sort of costs might they have in mind? What are the, you often hear the argument from Logan and from others that, the Fed can costlessly supply reserves, so they shouldn't artificially create scarcity, that doesn't make for an efficient system. What kind of costs might they?

Patricia Zobel: [00:28:59] I think it would be sort of the same cost that Chair Warsh sees, which is that the size of the balance sheet is interfering with monetary policy, that liquidity gets in the cracks and creates maybe more stimulus than we may anticipate, that there is interference with fiscal policy of a balance sheet this size. Those are the types of things. They're costs that are really hard to measure, or to assess.

Matthew Raskin: [00:29:32] So maybe that's a nice transition into the third sort of topic that we talked about in the context of the task force and the note that we put out, which is the size of the balance sheet. We were just talking about the idea that they're likely to maintain an ample reserves implementation framework, but look for ways to create efficiencies and ultimately bring the size of the balance sheet down. What do you think is actually possible there in terms of the amount by which they could reduce the balance sheet?

Patricia Zobel: [00:30:05] So I think it's difficult to say upfront that a certain amount, a number could be achieved. There are a range of estimates out there. My sense is there are some savings, but they may not be as large as some of the largest estimates that you've seen, some in the $1 to $2 trillion levels. Because I think some of those estimates assume that banks will rely almost entirely on the discount window. If you expand how they can rely on the discount window under internal liquidity stress tests, if they can count some of the collateral as High Quality Liquid Assets (HQLA). The estimates that they come up with are pretty large about how banks would change their liquidity management. Other estimates, they kind of add up. They have individual categories of savings, potential savings for reserve demand, and they add them up. And I think some of those are overlapping. And so, my sense is that you will have some savings. I think in particular, making aligning regulations, operations, and reducing stigma at the discount window, which is really complex, detailed work. If you can get that right, you probably make a big difference. If you can, over a long period of time, get US money markets to be as efficient as they might be, you could probably get liquidity savings. But my sense is getting back to 2000, we're right now a couple percentage points above as a share of bank assets above 2019 levels in terms of reserves to assets for banks. My sense is getting back to those levels would be a pretty good outcome. That would be around 500 billion in reserve demand.

Matthew Raskin: [00:32:06] Taking out in terms of reduction.

Patricia Zobel: [00:32:08] Reduction in reserve demand. In terms of the impact on the balance sheet size and the market implications, my sense is that all of this, as I said, is going to take time. And some of this is already likely priced in. So even if reserve demand shrinks, you aren't going to see the balance sheet shrink to the same degree. And that's because the other liabilities are growing at the same time. So for example, cash continues to grow. Other liabilities like some of the accounts will continue to grow. And this is, this means that they'll probably at most stop Reverse Repurchase Agreements (RMPs) or let MBS continue to run off. But that's going to be a gradual process. It's really shrinking the balance sheet relative to the counterfactual, not shrinking the balance sheet outright.

Matthew Raskin: [00:33:07] Got it. So I think people are very focused on the idea that the balance sheet could shrink by a couple 100 billion or more relative to where it is today. But as you're pointing out, maybe the right benchmark to have in mind isn't where the balance sheet is today, but where it would be in a world where no changes to balance sheet policy came from the task force or otherwise.

Matthew Luzzetti: [00:33:27] The other maybe interesting point there is before Chair Warsh was nominated, I think part of his argument around the balance sheet and thinking about the policy tools and inflation was that shrinking the balance sheet would reduce inflation either because of money supply or by tightening financial conditions. And that once that happened, then the Fed could cut the policy rate because inflation would have come down. But the timeline that you are outlining there, I think, is a very long one under which it doesn't seem very plausible that you could get the balance sheet shrinkage happening, that puts downward pressure on financial conditions, put downward pressure on inflation and allows the Fed to cut the policy rate anytime soon. Is that fair?

Patricia Zobel: [00:34:13] Well, yeah. And I, you know, I think just to go back to the principle of that, I think there is a relationship between the balance sheet size and the stance of monetary policy. So a lot of research models suggest about 1% of GDP in 10-year equivalents probably gets you about 10 basis points on the term premium, and that would give you a little bit more space to lower the policy rate if term premium rose a little bit. But those models suggest that QE and QT have the same impact. And so my sense is work that you did suggests that if you conduct balance sheet runoff smoothly and in a less stressed markets, you probably don't get a ton of impact. So there's some uncertainty about how much the balance sheet would give you space to reduce policy rates. And there are other factors, including how Treasury responds to the reduction in the balance sheet, whether or not they issue longer-dated securities or short-dated securities. So there's some uncertainty around it. And it's the type of theoretical discussion that fills up FOMC memos. We've had endless write-ups on these types of issues. But in practice, I wouldn't imagine, as you said, the FOMC actively tightening policy with the balance sheet in place of the rate policy. And that's because it's difficult to communicate two tools at once. And it's hard to finally calibrate balance sheet actions given all this uncertainty that we spoke about.

Balance Sheet Composition

[00:36:03] Matthew Luzzetti: I'm guessing you both contributed to many of those technical notes over time at the Fed. So maybe just going along the lines of that as we think about the last topic around maybe balance sheet composition, it seems, I think, safe to assume that the Fed is aiming for an all or primarily Treasury portfolio that's been part of their guiding principles for some time. Do you believe that they would consider selling MBS to maybe accelerate that process? Or are there other ways to get MBS off the balance sheet? We've heard talks or there's been ideas around doing a swap with the Treasury for MBS. Is there any real policies that the Fed could pursue over the near term which would allow them to accelerate the process of returning to an all-Treasury portfolio?

Patricia Zobel: [00:36:55] So I think it's, you know, the MBS portfolio is still about 30% of the SOMA portfolio, and that is much larger than the FOMC would like to see it. As we talked about before, they would like to return to a Treasury portfolio so that they are not influencing the allocation of credit in the economy. Still, I don't anticipate sales anytime soon. I think there's little incentive for the FOMC to risk disruption to the housing market at this moment. MBS has a smaller buyer base than Treasuries, and so active sales tend to have a bigger impact. I don't rule it out longer term when the housing market is a little bit more robust, because, but even then I would imagine that they're selling small amounts to keep runoff going, not really large sales. They don't have an interest in disrupting things to get the MBS portfolio down. There have been some interesting ideas on to lift the MBS portfolio out of the Fed's balance sheet. And that would maybe be a swap with Treasury has been discussed. I don't see that as terribly likely. The MBS portfolio is still held at a substantial mark-to-market loss. And so this doesn't have any implications for the conduct of policy because the Fed holds securities to maturity, but crystallizing that loss would mean that the Treasury would either have to recapitalize the Fed or that they would defer income even longer. And so my sense is that's not very likely. I don't think there's urgency to this reduction in the MBS portfolio.

Matthew Raskin: [00:38:47] And how about on the Treasury side in terms of the long run, the composition of the long run Treasury portfolio? This was a discussion the committee took up towards the end of last year. This was before Chairman Warsh had been appointed. And it looked from the minutes as though there was kind of an emerging consensus that the committee would target maturity distribution of the SOMA Treasury portfolio that roughly matches the universe of Treasuries outstanding. But there have been some on the committee who've suggested they go even further and hold an even shorter duration Treasury portfolio. And I think Warsh at his confirmation hearing or in some other venue recently suggested they shouldn't hold longer term assets at all. How do you think about where they might land in terms of the composition of the Treasury portfolio in steady state?

Patricia Zobel: [00:39:39] So, you know, that has been actively debated, you know, for the committee for some years, even before the pandemic, you know, there was active debate about how short the Treasury portfolio should be. And in part there are kind of two reasons why you want a shorter Treasury portfolio. One is to limit income risk and to limit risk of losses in particular. My sense is, it doesn't take a large overweight to short-dated securities in order to limit that income risk. In a steady state portfolio that matches the universe of Treasury securities, about 30% of the portfolio will be rolling over within two years. That's a lot of reset capacity. It's really asset purchases when you're purchasing long-dated securities in low-rate environments that create large income risk. So, I think for limiting income risk, you could probably shorten to about the Treasury universe and achieve objectives. In terms of gaining policy space, this is where the Chair might want to have a shorter portfolio for either for lowering rates or eventually for a maturity extension program under if their asset purchases were ever conducted again. There, I think again, the Treasury universe slightly shorter than the universe, probably achieves the Chair's objectives. There is, you know, the Treasury portfolio right now is pretty long relative to the Treasury universe of securities. And so my sense is they land somewhere too neutral, slightly short. But I think this is an area where there's more negotiation. I think the committee's more open to a shorter portfolio than the Treasury universe, maybe than imposing large costs on reserves. So I think there'll be some discussion around it.

Matthew Raskin: [00:41:37] Interesting. I guess one related question, and this is a topic of conversation with our clients, is I think there's a sense out there if the Fed were to go towards a very short-dated Treasury portfolio, that would have big implications in terms of duration in private portfolios and by extension the levels of term premia. But I guess my counterpoint to that is always to the extent that shift in the composition of the Treasury holdings is coming through reinvestments, it need not have any direct implication for the amount of duration that sits in private portfolios because Treasury is just elastically, because of the way the Fed does that as add-on at auction, Treasury is elastically supplying whatever it is the Fed decides to reinvest into. And it need not have any implications for what duration sits in private portfolios. Now, to the extent that Treasury then adjusts its issuance patterns in response to overall Treasuries outstanding, inclusive of what the Fed holds, it could. But I think there's this sort of inclination to treat a recomposition that comes through reinvestments as equivalent to what you get if the Fed were to sell in the secondary market and purchase in the secondary market. And in my view, they're very different. How do you think about that set of issues?

Patricia Zobel: [00:42:48] Well, I agree with that characterization that if the Treasury elastically responds by keeping private sector debt pretty constant, that there won't be a lot of impact on private portfolios. The question is, will they? And so for me, I see if the Fed goes a little bit short to the Treasury universe, I could see the Treasury pretty elastically responding to that. If you go very short to 50% bills of the ultimate all Treasury SOMA portfolio, that's a very large bill holdings. And the question is whether Treasury would adjust their debt management to accommodate that. And for me, I think during normal times, you want Treasury focused on debt management and you want Fed focused on monetary policy. If they're having to adjust their issuance for Treasury, for the SOMA portfolio holdings, that's a little bit less optimal. And under that circumstance where the bill holdings might be very large, they might be worried about, well, what if there is a MEP? We have to worry about that the Fed will run off those bills and we'll end up with more bills than we wanted. So I'm not sure they would elastically respond if you're skewed too far.

Task Force Deliverables and Outlook

[00:44:12] Matthew Raskin: Yeah, interesting.

Matthew Luzzetti: Those considerations are, I think, especially interesting as people were talking about a Treasury Fed accord heading into this period where you might, you know, there might be some benefits that you have alignment on the Fed and Treasury on some of these key issues. Maybe just to conclude, so we've talked, I think a lot about all the key issues around the balance sheet. Key question I think is what does the task force deliver? And then what does that actually mean for the balance sheet as we look ahead? So I think you've laid out how the Fed has significant expertise kind of throughout the system on all the issues that we've outlined here. So in your view, what is the likelihood that you get an external review that really changes key officials' minds on where the balance sheet should be? And to the extent that it matters, how do you view the leaders of the task forces as having kind of a key input into that, given that some of them do have reasonably well-defined views on the balance sheet?

Patricia Zobel: [00:45:14] That's a great question. Maybe I'll start with the second part first, which is that, Warsh picked a pretty impressive group of people for this task force. And so my hope is that we're going to get good recommendations on the balance sheet. Each one of them is well-regarded academics. They have deep perspective on issues around the balance sheet and implementation. You know, given their focal points, I think on the operating framework, they're pretty balanced. Stein has focused on the benefits of supplying reserves to this system, the financial stability benefits. Rajan's research, on the other hand, finds some ratcheting effects when you get asset purchases. So there's some balance there. And on active balance sheet policies, I think they've all been thinking hard about asset purchases and how they fit into the framework. So my sense is that the FOMC is going to be receptive to what they have to say. And I think one of the benefits of a public report is that they'll benefit not only from the recommendations, they're going to benefit from the public discourse around it. And so they're going to start with some recommendations, a lot of commentary on the recommendations, and then they're going to start internal work. And I think that's where my sense is that the recommendations themselves look a little bit more like a roadmap than a detailed menu. That given the focal points of these academically minded task force leads, that they're going to be setting out principles. They're going to be setting out ideas that they think are important. And I think that's some of the benefit of what they bring to this process is not that they're going to be doing, taking their five short months and doing new research. They're going to be examining existing research and weighing in based on their judgments. But the FOMC will take those recommendations and they're going to be considering that in the context of their own long experience with monetary policy implementation issues, as far back as 2015, they did a zero-based review of operating frameworks, and a lot of research came out of that, and they maintain a lot of expertise. So I think they're going to be very open to ideas. I think there will be places where their minds will be, if not changed, influenced. But I think it will be kind of an interaction between the task force's expertise and their own.

Matthew Raskin: [00:48:00] Great. Listen, this has been a wonderful discussion, Patricia. I've learned a ton today. Really appreciate you taking the time to share your views with us.

Matthew Luzzetti: Yeah, thank you. It's been fascinating, insightful, and it sounds like we might have a topic to discuss again at some point as we get some information from the task forces. It's not something that will be concluded soon. So thanks so much, Patricia.

Patricia Zobel: Yeah, it was my pleasure. It was great to talk with you both.

Matthew Luzzetti: If you'd like more information on anything discussed here today, please reach out to your Deutsche Bank sales representative. This is Matt Luzzetti and Matt Raskin, and you've been listening to Macro Matters.

[Unidentified Speaker]: Podzept, the podcast from Deutsche Bank Research. This podcast has been produced by Deutsche Bank and may contain research as defined in Mifid II. The information discussed is believed to be reliable and has been obtained from public sources believed to be reliable, although Deutsche Bank makes no representation as to its accuracy or completeness. Opinions, estimates and projections discussed constitute the current judgment of the speaker at the time of recording. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. For further important information, please visit research.db.com.

Key Takeaways

1. Balance Sheet as a Central Tool: The Federal Reserve's balance sheet is a central tool for monetary policy and financial stability, providing liquidity, implementing rate policy, and supporting the US dollar's trust. In crises, its unconstrained nature allows for an "elastic currency" and asset purchases (QE) to lower long-term rates.
2. Chair Warsh's Criticisms and FOMC Views: Chair Warsh views the balance sheet as potentially blurring monetary and fiscal policy, distorting market signals, and contributing to inequality. While the FOMC broadly supports using balance sheet tools in crises, they may not share the amplitude of Warsh's critiques regarding its impact on monetary policy and fiscal interaction, seeing liabilities as fulfilling important roles to be supplied as demanded.
3. Future of Asset Purchases (QE): QE will likely remain a tool, particularly at the zero lower bound or during market dysfunction, but needs a clearer framework. This framework should define circumstances for use (e.g., materially constrained by ZLB), develop distinct design principles for market functioning vs. accommodative purchases, and ensure clear communication with transparent transition points. MBS purchases are likely to be used more judiciously, primarily to address housing market stress, given the Treasury market's increased capacity.
4. Ample Reserves Regime to Remain: The Fed is expected to maintain its ample reserves operating framework due to its benefits for rate control, financial stability, and supporting the Treasury General Account (TGA). However, the task force will seek to improve efficiency by reducing the demand for reserves.
5. Strategies to Reduce Reserve Demand: Efforts will focus on encouraging banks to rely more on Fed liquidity backstops (e.g., discount window) and modernizing fragmented US money markets (e.g., 24/7 tokenized payments). The task force will likely explore ways to reduce reserve demand without imposing costs on reserves (like tiering IORB), though this remains a possibility if the costs of supplying reserves are deemed too high. Returning to truly scarce reserves is unlikely due to payment system risks.
6. Balance Sheet Size Reduction: While some savings in reserve demand are possible (potentially around $500 billion, aligning with 2019 levels as a share of bank assets), the overall balance sheet size may not shrink proportionally due to growth in other liabilities like cash. Any reduction will be gradual, relative to a counterfactual, and may not translate to quick policy rate cuts as Warsh might have anticipated.
7. Balance Sheet Composition - Treasury Focus: The Fed aims for a primarily Treasury portfolio. Direct MBS sales are unlikely in the near term to avoid housing market disruption, though smaller, gradual sales could occur long-term. A Treasury-MBS swap is deemed unlikely due to mark-to-market losses.
8. Treasury Portfolio Duration: The committee is likely to target a SOMA Treasury portfolio maturity distribution that roughly matches the universe of Treasuries outstanding, or potentially slightly shorter. The aim is to limit income risk and gain policy space, but not to the extent of holding predominantly short-term assets, which could impact Treasury debt management and fiscal policy.
9. Task Force Deliverables and Influence: The task force, composed of well-regarded academics with diverse views, will deliver principle-based recommendations rather than detailed instructions. These recommendations will serve as a roadmap, influencing FOMC discussions and internal work, potentially leading to mind shifts among officials. The process will be an interaction between external expertise and the Fed's own long-standing internal knowledge.
10. Longer-Term Process: Changes stemming from the task force will be a gradual and complex process, requiring internal work and multiple discussions within the FOMC. It is not an immediate fix for current monetary policy challenges but a long-term evolution of the Fed's operational framework.

Disclaimer

This transcript has been generated using artificial intelligence and may contain minor inaccuracies or omissions. For complete accuracy and context, please refer to the original podcast recording here.

Executive Summary

This podcast, "Best of British," discusses the economic and political landscape of the UK, focusing on "Manchesterism," the vision of the new Prime Minister, Andy Burnham. Key topics include Burnham's five policy pillars (devolution, housing, reskilling, reindustrialization, and cost of living), the challenges facing the UK government, potential fiscal policies, and the outlook for the Bank of England's monetary policy and Sterling. The speakers highlight the difficulty of enacting significant change quickly but also note signs of resilience and potential for productivity growth in the UK economy.

Cleaned & Structured Transcript

Introduction to "Best of British" Podcast

[00:00] [Unidentified Speaker]: Just a quick note before we begin, you'll find important disclosures, analyst certifications, and historical recommendations in respect of the securities we're discussing on the Deutsche Bank Research website.

[00:00:19] Jonathan Jayarajan: Welcome to Deutsche Bank's podcast, "Best of British," a brand new podcast looking at the key issues affecting the UK economy. I'm Jonathan Jayarajan, the Head of European Equity Product at Deutsche Bank. This will be a six-weekly podcast, just ahead of the Bank of England (BOE) meetings, designed to keep you informed of the key issues in the UK. Today, I'm delighted to be joined by two guests: Sanjay Raja, our Chief UK Economist, and Shreyas, our Senior FX Strategist and sterling guru.

Sanjay Raja: It's great to be here, JJ. I'm very excited to do this podcast. I'm sure we'll have a lot of fun speaking about UK economics and politics, especially when we bring in some of our star research guests like my colleague Shreyas.

Jonathan Jayarajan: Yes, indeed. Shreyas, thank you for joining us as well.

Shreyas: Pleasure to be here. Really excited to dig into all things UK and markets.

Understanding Manchesterism

[00:01:27] Jonathan Jayarajan: Guys, we're kicking this podcast off at a very opportune time with the change of government, a new prime minister, and new strategy announcements already out. Manchesterism is clearly a concept very familiar to that part of the country, maybe not so much to the rest of the UK and to our international audience. Sanjay, maybe you can kick us off and give us an idea of what Manchesterism actually is.

Sanjay Raja: Thanks, JJ. There are so many things going on in the UK space. We have our fifth Prime Minister in just about four years. There's a lot of conversation about fiscal policy and monetary policy, clearly still in the limelight for the UK. The new Prime Minister in the UK has talked a lot about something he's very passionate about, which is Manchesterism. That, JJ, is the billion-pound question for markets and our clients: What is Manchesterism? It's what market participants are trying to figure out in the first few weeks of Burnham's premiership.

In essence, Manchesterism is Andy Burnham's vision for leveling up the economy. There are five pillars that define his version of Manchesterism:

Devolution: This has been discussed a lot recently and in the last five years. Boris Johnson talked about the leveling up strategy, and 15 years ago, under the Blair-Brown era, we talked about regional development agencies. This isn't new, but for Andy Burnham, this is a key pivotal focal point for his agenda. The Manchester success model is ultimately based on successful place-based policy built over decades. Place-based policy played a critical role in shaping Manchester's success over the last 10 years. Burnham wants to empower local regions, city regions, and towns. He wants city regions, local regions, and councils to take control of their own economic development strategy. Given that the UK is one of the most centralized OECD countries, that pivot to devolution is a necessary step. Devolution created Manchester's economic success, and Burnham wants to scale this up and down the country.

Housing: Burnham wants to undertake the biggest housing development project since the Second World War. It's a big task and will cost a bit of money. He's focused on social housing. This isn't a new ambition; the previous Starmer government had an ambition to build about a million homes over five years. There's a revived focus on housing. The idea is simple: the government would give households the homes they need to live and thrive, which will lead to better growth and productivity outcomes. There is a lot of academic literature talking about the importance of housing in regional growth and productivity. To deliver this, Burnham, his team, and his Housing Secretary, Angela Rayner, will need to be quick and strong on housing reform and planning regulations. He tried to roll this out in Manchester with some success and is planning to push it on a national, broader scale.

[00:05:00] 3. Reskilling: Andy Burnham has been very vocal about the education system in the country, suggesting it may not be fit for all. His proposition is that we all can't go to university. Each city and region will have specific labor demand needs, be it technical, polytechnic, or manual. The idea is to build a diversified 21st-century workforce ready to deal with the changing landscape of global economic forces. In Manchester, Andy Burnham was proud of his Manchester baccalaureate program that he created and designed, and he wants to scale that up nationally: a skills program that affords everyone a role and a place to study, but also improves labor market matching at the same time. This is similar to the German model.

Jonathan Jayarajan: That makes a ton of sense when you think about how technology is developing, and where AI is going to be in 10-15 years.

Sanjay Raja: Absolutely. Think about the deglobalization phenomenon. Think about the housing strategy. We need more bricklayers; we need more technical skills that we've lost over the last two, three, four decades as we've become more of a services-based economy. This is a goal that Rachel Reeves and Keir Starmer started to think about, and Andy Burnham wants to supercharge that using his Manchester baccalaureate as a prototype for a national reskilling project.

Reindustrialization: JJ, you've heard us talk about reindustrialization. It's a global story, not unique to the UK. We're seeing it in Germany, Canada, the United States, and other parts of Europe. Starmer and Reeves set out a decade-long plan to deliver on reindustrialization, and Burnham is building on this. It's not about redefining reindustrialization but about delivering that strategy and plan. It's about sector diversification and rebuilding the hollowed-out manufacturing sector in the UK, geared to the 21st century. The focus is on net zero, defense, and AI, for example. In a world of deglobalization, the chase for reindustrialization has certainly become more fashionable because it creates less dependency on global value chains and global supply chains. It strengthens resilience, builds jobs, and fosters growth, but it is not costless. There will be trade-offs, winners, and losers, and this is something Burnham will have to come to grips with, as the previous government did.

Cost of Living: This is a big problem and a major focus area for voters, households, and businesses. Herein lies the crux of his agenda: taking public control of essentials. We've heard Burnham speak a lot about this. The newly appointed Chancellor also focuses on households' purse strings and easing the cost of living. Burnham has talked about nationalization and putting more money back into households' pockets to break the feeling that households feel constantly poorer as time wears on. The higher inflation we've seen clearly plays a role in that. It's about reducing inflation, reducing CPI, and maximizing household disposable incomes. It's an ambitious goal, but he's already started to work on it. On his second day in office, he cut VAT on electricity bills, which could cost just under a billion pounds. He's hyper-focused on delivering on that. We know there will be more, such as a cap on bus fares and more action on energy bills in his first budget. Those five pillars define Manchesterism: cost of living, reindustrialization, reskilling, housing, and devolution.

[00:09:57] Jonathan Jayarajan: And we did have the business rates announcement this morning around the pub settlement, which will ultimately feed into the cost of living issue. With that in mind, Sanjay, do you think this is the policy set that's likely to address the key issues that voters have been talking about over the last few years?

Challenges and Voter Priorities

Sanjay Raja: The ultimate success for Burnham and his new cabinet is what comes in the next election. That will be the litmus test for Burnham and his government. It's a tall task, given where the polls are, but he is popular. It is a big challenge. Politics, as we know in the UK, as with many other countries, has become more divided. So it really sets him up in terms of how he delivers on some of the pillars of Manchesterism. What would keep him in Number 10, if that's what we define as success for voters?

Let's go back to the cost of living. Our DBDig surveys, which are weekly household surveys, show that the biggest concern for some time, really since the pandemic, hasn't been the NHS, immigration, or even defense. It has come down to the cost of living: how poor households feel, how better-off households feel, and whether they feel the government is working for them. These are the kinds of questions Andy Burnham and his team will have to come to grips with. Voters' patience on this is getting more and more limited. We live in this quick, click-bait world, and in some ways, that has made the challenge for any prime minister. If he can convince households that their cost of living has improved, that will certainly be a vote-getter, hence some of the policies he's announced in his first week as Prime Minister.

The second thing, it always comes down to it. We have an aging society, JJ. It's the NHS, the healthcare system. Many feel that the NHS hasn't worked well for them; it's been stressed and stretched over the last couple of decades. We haven't had as much funding as it may have needed to stay at the state-of-the-art architecture or infrastructure that we need. We have an aging demographic, and this is the truth that all societies in the West and in advanced countries have to deal with. This is why he's also keen on introducing a national social care system to complement the NHS, and why he's so keen on ensuring reduced waiting lists. That's been the priority for the last government, and it will surely be Burnham's too. That may be one of the tests he puts to his own cabinet to see whether or not that passes in terms of the electorate's appetite for keeping Burnham in government.

[00:13:00] The third thing, of course, has been a topic of discussion for some time now: immigration. It's a double-edged sword. You need immigration for growth to some extent; it's been such a lifeline for productivity growth in the UK. But there's a widely held view that immigration hasn't worked for many British households. A good chunk see immigration as a problem that has contributed to some of the fallen living standards. It's why Shabana Mahmood, the Home Secretary in the previous government, turned hawkish on immigration policy. Voters will want to feel protected, not just externally, but at home. This is why Andy Burnham left Shabana Mahmood as Home Secretary in his new government. It wasn't a very popular decision within his own party, but it emphasizes the central tenet about how important immigration is, not just to his cabinet, but ultimately to the voter on the street. If he can make a good dent on all three things—immigration, the NHS, and the cost of living—I think that's what will eventually convince voters to perhaps vote for Burnham in the next general election, whenever that may be. At the moment, two and a half years; who knows, that could be earlier. But the proof will be in the pudding.

Jonathan Jayarajan: Defense will be an important area of spend. Obviously, his appointment as Chancellor of the Exchequer helps to ensure that. I'm sure that will be a material issue by the time we get to the next election as well.

Upcoming Budget and Fiscal Outlook

Jonathan Jayarajan: Speaking to the shorter term, obviously, we're going to have a budget upcoming. We've seen a number of announcements already. What else should we expect within the budget? What are the markets fearful of? Are we going to see further tax-raising measures?

Sanjay Raja: It's a great question, and perhaps this is the biggest domestic policy event we get all year. Markets are becoming very interested in what Manchesterism means from a fiscal policy perspective. It's well and good to talk about Manchesterism as a policy ideal. What does it mean in practice? Ultimately, for investors, JJ, to your point, what are markets afraid of? Markets are afraid of how much it's going to cost ultimately to investors. Are bond markets, are gilt yields priced effectively on the back of Manchesterism? That's the multi-billion pound question that we have.

He will have an inaugural budget. Let's remember Reeves' inaugural budget; that was seismic, historic. We had 70 billion pounds of extra borrowing added at the very end. We had a huge spending spree. We had huge taxation as well, in spite of the Labour Party manifesto. So markets are coming out of that world two years ago and thinking, will Andy Burnham try and mimic what Rachel Reeves did? John Healey is a safe pair of hands, but his fiscal challenge is still enormous. The Iran shock has eroded fiscal buffers. On our estimates, JJ, we're thinking something like 10 billion pounds. So by the time we start to put pen to paper, there's already a pretty steep cost that he and his team will have to deal with.

You mentioned defense, JJ, and I think that's very important. John Healy has been very vocal about increasing defense spending to 3% of GDP, not in 2035, but before 2030, and that's going to cost something like 5 to 10 billion pounds on top of the defense investment plan that was announced a couple of weeks ago. So that's going to add to the fiscal cost side of things.

[00:16:30] On the spending side, beyond defense, we know that there may be a medium-term spending review. I think this is where our clients are starting to put a lot more focus on because unprotected departments face a big real-term squeeze in the coming years. On current plans, we will see departmental budgets squeezed quite a bit, unrealistically perhaps. The case was always going to be that no matter who was in Number 11, those budgets would be topped up as part of a spending review, a medium-term spending review. How much could that cost, JJ? On our estimates, we're talking about another 10 to 15 billion pounds. So that's a sizable chunk that Andy Burnham and his team will have to grapple with in the coming budget.

Then, JJ, you've got social care reform. I mentioned this at the start; it isn't going to be cheap. Estimates we've heard on social care reform or a national social care service have ranged between 15 and 20 billion pounds. It may not happen this year, possibly, and it probably won't, realistically. It may be something that Burnham keeps for the next parliament, but it is something that if he wants to grasp the nettle on social care reform, he could announce as part of his inaugural budget. Big picture, if you total all of this up—social care reform, the day-to-day spending top-up on the spending review, defense potentially, the Iran shock and the cost that that's hit the public finances—we're talking about something like a 30 to 40 billion pound potential gross budget. That's a big spending number. He will need to raise taxes. We'll see where he goes on that front.

Jonathan Jayarajan: Sanjay, I was going to ask you about that because 30 to 40 billion, that is a big number, right?

Sanjay Raja: Absolutely.

Jonathan Jayarajan: What forms of taxation do you think we are most likely to see the hikes in? Alternatively, can the government just decide it's going to borrow more, accept higher borrowing rates? And if they do, what are the consequences of that path?

Sanjay Raja: I think they will borrow more; that's the inevitable destination. But they're not going to borrow 40 billion pounds more. There will be more taxes, I'm fairly confident. There are fiscal buffers. John Healy, the new Chancellor, and Andy Burnham, the new Prime Minister, have both committed to the previous Chancellor's fiscal rules. That means they will have to meet a current budget balance by 2029-2030. So that's in the legislation. They will have to make sure the debt, defined as public sector net financial liabilities, comes down as a share of GDP in that same time period. That will limit how much they can do on a borrowing perspective, but they can increase borrowing by maybe 10, maybe 15 billion pounds if they choose to; that will be a political decision for them. The question then will be really about how much taxation they want to offset this with.

There's a big question here, JJ, because obviously, we talked about the cost of living. Households don't want more taxes to feel like their cost of living is getting worse. So there is a trade-off here for the government to make. Maybe they water down a lot of these plans, JJ, ultimately. Maybe this budget isn't as big as we kind of think it could be. So that is perhaps one avenue. But if they do decide to go big, what can they look at? Property taxes, I think, is number one. It's something Rachel Reeves talked about a little bit and scratched the surface of last year with the council tax surcharge on mansion tax, if you remember that. So we could get more on that. We could get an estate death tax; this is something Andy Burnham has talked about before as a potential means to pay for a National Health Service. We've heard talk about a warehouse tax, so that's an Amazon tax potentially that could come into the budget. Increasing capital gains tax, that's something that Andy Burnham and his team have talked about as well. So there are a few channels that they can take. They're ambitious, they're big taxes. They're hard to implement quickly. So this will be the challenge from a market perspective. When you ask me, going back to the question about what markets are afraid of, well, number one, they're afraid about how much borrowing Andy Burnham is going to ask from them. But if we do get fiscal consolidation, and it's likely we do, when does it kick in? That's going to be a big question from a market perspective.

Monetary Policy and Sterling Outlook

[00:20:35] Jonathan Jayarajan: So when we pull all of those possibilities as elements together, interest rates are another material cost in people's lives. Where do we think the path of the BOE is from here?

Sanjay Raja: Our base call at the moment, JJ, is no change in bank rates. We have the bank rate at 3.75% for the rest of the year. We have two cuts penciled in for next year. So we think the bank rate will get to what we think is a neutral rate estimate of 3.25%. That's been our long-held view since October 2024, in Rachel Reeves' inaugural budget. We've stuck to that view and feel comfortable with it. The question is, if we get a lot of upfront fiscal stimulus, does that challenge that neutral rate view? That's where I'll start to get a bit more nervous. If we do tend to see a lot more spending and a lot more delayed consolidation, that could allow the Monetary Policy Committee (MPC) to potentially keep rates a little bit more restrictive for longer. And that's going to be a big question. So from an interest rate perspective, I think the risk is still one way. It's either keeping rates steady, as per our base case, or cuts next year, which is our base case, that may start to wind off, and that may start to erode in terms of probability. And so that's what we'll be watching for very closely in the autumn.

Jonathan Jayarajan: That's very clear, Sanjay. Thank you. Shreyas, maybe I can come to you now, and we think about the outlook from a currency perspective for Sterling, given what Sanjay said so far. What's your view on where we're heading?

Shreyas: Yeah, it's fascinating because for all the news flow that there's been over the course of the year, the past several years, one of the bastions of stability within the UK has actually been in recent years the currency. Starmer's premiership, those two years, saw one of the narrowest ranges for the pound on record expressed against the euro. That's largely because of that monetary policy anchor that we've had; rates have been restrictive. Maybe that's had a negative impact on growth, but it has been a supportive factor for the currency.

One of the interesting dynamics over the past couple of months is that sterling has actually been one of the best-performing currencies despite all of this political uncertainty, this uncertainty over the path going forward. That's because the pound had built in an additional risk premium over and above that anchor of that monetary policy cycle and where the Bank of England's path was heading. When sterling is, as it has been for a few years, quite a low volatility currency pair, we were talking about something in the region of 2% to 3% cheapness in the pound, which for a low volatility pair is relatively material. In that context, the absence of more negative news really over the past couple of months, commitment to the fiscal rules, lack of real clarity over how much borrowing, how much tax we're going to get, that's been enough for Sterling to do quite well.

[00:23:30] From here, though, we've sort of changed that view and turned more neutral, having been more constructive on the pound, because the risks are more balanced. There is this level of uncertainty between, say, a Bank of England path of two cuts next year versus what the market is now pricing again, as of this morning, which is closer to three hikes by the middle of next year, in part because of the resumption of the rise in energy prices. I think that's the key point for some factors like the currency going forward. For all the domestic focus, which is right, and there's a long list of potential policies, some of which may come into play, some of which won't, from a sterling perspective, if energy prices keep rising, we're an importer of energy, that will worsen the trade balance. At the same time as energy prices rise, the fiscal pressures or the pressures on this cost of living channel, one of these arrows of Manchesterism that Sanjay outlined, that pressure to do more on energy spending or on energy prices will only increase further.

So I think it's key to keep in mind that external environment, as long as, and maybe we'll touch upon next week's meeting, as long as the Bank of England keeps a hawkish bias, which has been Sanjay's call, that should limit the extent of deterioration in the pound, even as energy prices go. But it all becomes a little bit more uncertain as we head towards the budget, these tales around the level of spending, how much of it will be offset by tax rises. Some of those tax rises might be seen as more currency negative than others, depending on where we get to, depending on how it impacts flows into UK assets. So there's a bit more uncertainty that's picking up from this point of view, where that risk premium in the pound has sort of eroded and is more fairly valued. I think a neutral bias for now makes more sense.

Government's Toolkit and Economic Outlook

[00:25:11] Jonathan Jayarajan: That's very clear, Shreyas. Maybe to close the podcast, I can ask you both a question. When we think bigger picture, has the government got enough in its toolkit that by the time you get to the next election, they could have made a meaningful difference to people's wealth, feeling not just the cost of living, but whether they actually feel wealthy, perhaps change the political direction in favor of the existing government, or do you think that's going to be a very challenging, limited amount of headroom to perhaps change?

Sanjay Raja: It's a great question, JJ, and I think the jury's out. It's a tall task. Households have felt shortchanged for not just two, three years; it's been a five-year story and beyond. So it's going to take time for any of these government policies to really have any effect. These are supply-side policies. If you look at the Office for Budget Responsibility (OBR) calculations, these things take at least five years to work their way into the real economy. So you can't really expect a lot of these things like reskilling, rehousing, and reindustrialization to have a huge quick effect, a positive effect, on how people's perceptions of the cost of living and their personal finances are. So in some ways, I think it is going to be super challenging for Andy Burnham to do and deliver on some of those pillars and to make people, households, and businesses feel better off than they were.

But at the same time, I will say, maybe from my perspective, to end on a slightly positive note, there are signs of resilience in the economy. There are signs of positivity in the economy. And it's all relative, right? It's all relative to where we were two, three years ago. It's all relative to other countries. We can't just look at the UK in isolation. Every country has been facing some of the same issues that the UK has been facing. We aren't working in a silo. We are seeing growth in the UK economy. The UK was the fastest-growing economy in the G7 in Q1. It looks like it's holding up into Q2. We're seeing some signs of stabilization in the labor market, so that's something to take away from. Inflation, yes, it's well above target; that's not great, but it has undershot expectations quite meaningfully. We're already tracking about 40 basis points below the Bank's headline forecast, for example, JJ. So that's positive.

[00:27:30] We are seeing tentative signs, JJ, that productivity growth, which has been elusive, could be making a comeback. If you look at UK growth last year, we grew 1.3% as an economy. And if you trust the HMRC data, we had 100,000 fewer employees that generated that growth. No forecaster would have expected that with that sort of mix. So there is this thought process that maybe, just maybe, with the advent of digitalization and automation picking up more steam, artificial intelligence obviously in the background working its way through the real economy, that productivity growth is improving, is increasing. And that's the ultimate ingredient for improving living standards. So I'm a little bit more hopeful than I have been in the past. If Andy Burnham can get some of these pillars to hit broadly close to the mark, I think households and businesses may start to feel some of that positivity as well.

Jonathan Jayarajan: That's actually a great place to perhaps end our first podcast. Shreyas, Sanjay, thank you both very much for joining us. This is our "Best of British" podcast. As I mentioned earlier, we'll be looking to run on a six-week cycle ahead of the BOE to keep you informed on some of the key issues in the UK. I'm Jonathan Jayarajan here at Deutsche Bank. Thank you very much for joining us.

[00:28:47] [Unidentified Speaker]: This podcast has been produced by Deutsche Bank and may contain research as defined in MiFID II. The information discussed is believed to be reliable and has been obtained from public sources believed to be reliable, although Deutsche Bank makes no representation as to its accuracy or completeness. Opinions, estimates, and projections discussed constitute the current judgment of the speaker at the time of recording. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. For further important information, please visit research.db.com.

Key Takeaways

Manchesterism Defined: Prime Minister Andy Burnham's "Manchesterism" is a comprehensive vision for the UK economy, built on five pillars: devolution, social housing development, national reskilling programs, reindustrialization (focused on 21st-century sectors like net-zero and AI), and addressing the cost of living crisis through public control of essentials and inflation reduction.

Fiscal Challenges: The new government faces significant fiscal hurdles, with potential gross budgetary needs estimated at 30-40 billion pounds due to the Iran shock, increased defense spending, potential medium-term spending reviews, and social care reform. This will likely necessitate a combination of increased borrowing and new taxation measures.

Potential Tax Hikes: To offset significant spending, the government may consider property taxes (e.g., estate death tax, council tax surcharge), a "warehouse tax" (e.g., Amazon tax), and increased capital gains tax. The challenge lies in balancing tax increases with the desire not to worsen the cost of living for households.

Monetary Policy Outlook: Deutsche Bank's base case for the Bank of England is no change in the bank rate at 3.75% for the rest of the year, with two cuts penciled in for next year, reaching a neutral rate of 3.25%. However, significant upfront fiscal stimulus could challenge this view, potentially leading the MPC to keep rates restrictive for longer.

Sterling's Neutral Stance: After a period of stability and outperformance, Sterling's outlook is now considered more neutral. While the pound had built in a risk premium, external factors like rising energy prices (which worsen the trade balance for the UK as an energy importer) and the uncertainty surrounding the budget's fiscal details could introduce more volatility.

Long-Term Impact: While the government has ambitious plans, many are supply-side policies that take years to yield significant results (e.g., OBR estimates suggest at least five years). Therefore, it will be challenging for the government to demonstrate a meaningful improvement in people's wealth and living standards by the next election.

Signs of Economic Resilience: Despite challenges, there are signs of resilience and positivity in the UK economy, including strong Q1 growth (fastest in G7), stabilization in the labor market, and inflation undershooting expectations. There's also tentative hope for a resurgence in productivity growth, driven by digitalization, automation, and AI, which is crucial for improving living standards.

Disclaimer:

This transcript has been generated using artificial intelligence and may contain minor inaccuracies or omissions. For complete accuracy and context, please refer to the original podcast recording here.