Is the Bank of England losing money the more it shrinks its balance sheet? The underlying fiscal mechanisms are more complex than the market imagines.
2026-08-18 21:11:00
On Tuesday, August 18th, the UK bond market faced renewed upward pressure on long-term interest rates. The yield on 10-year UK government bonds rose to approximately 5.08% intraday, and the yield on 30-year bonds rose to approximately 5.86%, placing long-term financing costs at a relatively high level in recent years. The Bank of England's current policy rate remains at 3.75%, having decided to hold it steady at its July meeting by a 6-3 vote, although three members supported raising the rate to 4%. The latest released June CPI showed a year-on-year increase of 2.6%, while July inflation data will be released on August 19th. With interest rates, energy prices, and long-term bond yields all within sensitive ranges, market focus is shifting from the Bank of England's next interest rate decision to the upcoming announcement on September 17th regarding the scale of the new fiscal year's quantitative easing. The Bank of England has decided in September 2025 to reduce its holdings of UK government bonds in its asset purchase program by £70 billion between October 2025 and September 2026, bringing the total to £488 billion. By the end of June 2026, holdings of relevant government bonds had fallen to £521.8 billion. The Bank of England will reassess the scale of its balance sheet reduction over the next 12 months at its policy meeting on September 17th, meaning the market will soon receive important parameters regarding the next phase of proactive bond sales and redemption arrangements. It is worth noting that the median expectation for the balance sheet reduction from October 2026 to September 2027, given in the July market participant survey, is £50 billion, lower than the current annual target of £70 billion. At the same time, respondents expect the proportion of proactive sales of long-term government bonds to be significantly lower than that of short- and medium-term bonds. This indicates that market focus is shifting from the sheer amount of balance sheet reduction to the term structure, government bond supply, and the absorption capacity of the long-term market. 
This change is particularly important. Quantitative tightening is not simply a matter of subtracting numbers from the balance sheet. The central bank's large holdings of bonds were purchased during a period of low interest rates, and now long-term yields are significantly higher than those levels, meaning these assets could incur actual losses upon sale. Simultaneously, reserve interest costs rise with policy rates, causing the asset purchase instrument to continue to face negative interest rate spreads. To understand the current problem, two accounts need to be broken down. The first is the holding cost. During quantitative easing, the Bank of England purchased government bonds and paid for them by creating central bank reserves. During periods of low interest rates, government bond coupon income generally exceeded reserve interest costs, thus the asset purchase instrument could continuously generate cash returns. However, with the change in the interest rate environment, this mechanism has reversed. The Bank of England still holds a large amount of historically low-coupon government bonds, but needs to pay interest on commercial bank reserves at higher policy rates, resulting in negative interest rate spreads. The UK Office for Budget Responsibility previously projected that related interest losses for the 2025-2026 fiscal year would be in the range of approximately £11 billion. The second comes from losses on bond sales. Rising interest rates mean falling bond prices. Assets purchased by the Bank of England during periods of low yields could result in capital losses if sold in the current environment of higher yields. The UK's Office for Budget Responsibility's March fiscal forecast indicated approximately £2.4 billion in losses from asset purchases in the 2025-2026 fiscal year. Therefore, the real concern is not a single quarterly loss, but a persistent maturity mismatch on the balance sheet. The Bank of England holds a large amount of fixed-income assets, and the cost of reserves in its corresponding liabilities fluctuates rapidly with policy rates. When policy rates are consistently higher than the average yield of the portfolio, negative interest rate spreads persist. This is where the controversy arises. Some major central banks do not immediately have the Treasury cover such losses in cash, but instead allow the central bank to defer them on its balance sheet, waiting for future income to gradually offset them. The current UK system is different. The Treasury is liable for compensation for asset purchases, so when the central bank incurs related cash losses, the Treasury needs to transfer funds. On the surface, if the compensation arrangement were removed, the Treasury would seem to be able to immediately reduce cash expenditures. However, from the perspective of public sector balance sheet consolidation, the economic consequences would not disappear. The central bank itself remains part of the public sector. Whether losses are recorded in the Treasury's books or temporarily placed on the central bank's balance sheet essentially changes the timing of recognition and financing channels, rather than eliminating the losses. The difference lies more in the financing structure. Currently, the Treasury needs to cover its cash needs through government bond financing. If losses remain with the central bank, they may manifest as increased reserve liabilities, which require paying the policy interest rate. Which financing method is cheaper depends on the relationship between the policy interest rate and the yields of government bonds of different maturities. Currently, the UK yield curve is upward sloping, with long-term government bond yields significantly higher than the 3.75% policy interest rate. Therefore, in the short term, the cost of reserve financing may be lower than that of long-term government bond financing. However, this is not a permanent advantage; once the shape of the yield curve changes, the cost relationship will also change. Therefore, accounting system adjustments can change the pace of loss occurrence, but cannot eliminate the economic costs left by quantitative easing. The Bank of England has previously clearly stated that the policy interest rate remains the main tool for adjusting the stance of monetary policy, and quantitative tightening should avoid disrupting market operations as much as possible. The scale of active bond sales in the third quarter of 2026 has been clearly controlled, with only short- and medium-term government bond auctions arranged from July to September, and no active sales of long-term bonds arranged. This gives the September decision a dual meaning. On the one hand, the new fiscal year's balance sheet reduction target determines how much existing government bond the central bank releases into the market. On the other hand, the maturity structure of proactive bond sales will overlap with the issuance of new government bonds by the fiscal authorities, affecting the duration risk that the market needs to absorb. Therefore, whether it is £50 billion or £70 billion is not the only variable. The proportion of proactive sales, the scale of redemptions upon maturity, and the weight of long-term government bonds in the sales plan also determine the actual impact of quantitative tightening on the market's supply and demand structure.
This change is particularly important. Quantitative tightening is not simply a matter of subtracting numbers from the balance sheet. The central bank's large holdings of bonds were purchased during a period of low interest rates, and now long-term yields are significantly higher than those levels, meaning these assets could incur actual losses upon sale. Simultaneously, reserve interest costs rise with policy rates, causing the asset purchase instrument to continue to face negative interest rate spreads. To understand the current problem, two accounts need to be broken down. The first is the holding cost. During quantitative easing, the Bank of England purchased government bonds and paid for them by creating central bank reserves. During periods of low interest rates, government bond coupon income generally exceeded reserve interest costs, thus the asset purchase instrument could continuously generate cash returns. However, with the change in the interest rate environment, this mechanism has reversed. The Bank of England still holds a large amount of historically low-coupon government bonds, but needs to pay interest on commercial bank reserves at higher policy rates, resulting in negative interest rate spreads. The UK Office for Budget Responsibility previously projected that related interest losses for the 2025-2026 fiscal year would be in the range of approximately £11 billion. The second comes from losses on bond sales. Rising interest rates mean falling bond prices. Assets purchased by the Bank of England during periods of low yields could result in capital losses if sold in the current environment of higher yields. The UK's Office for Budget Responsibility's March fiscal forecast indicated approximately £2.4 billion in losses from asset purchases in the 2025-2026 fiscal year. Therefore, the real concern is not a single quarterly loss, but a persistent maturity mismatch on the balance sheet. The Bank of England holds a large amount of fixed-income assets, and the cost of reserves in its corresponding liabilities fluctuates rapidly with policy rates. When policy rates are consistently higher than the average yield of the portfolio, negative interest rate spreads persist. This is where the controversy arises. Some major central banks do not immediately have the Treasury cover such losses in cash, but instead allow the central bank to defer them on its balance sheet, waiting for future income to gradually offset them. The current UK system is different. The Treasury is liable for compensation for asset purchases, so when the central bank incurs related cash losses, the Treasury needs to transfer funds. On the surface, if the compensation arrangement were removed, the Treasury would seem to be able to immediately reduce cash expenditures. However, from the perspective of public sector balance sheet consolidation, the economic consequences would not disappear. The central bank itself remains part of the public sector. Whether losses are recorded in the Treasury's books or temporarily placed on the central bank's balance sheet essentially changes the timing of recognition and financing channels, rather than eliminating the losses. The difference lies more in the financing structure. Currently, the Treasury needs to cover its cash needs through government bond financing. If losses remain with the central bank, they may manifest as increased reserve liabilities, which require paying the policy interest rate. Which financing method is cheaper depends on the relationship between the policy interest rate and the yields of government bonds of different maturities. Currently, the UK yield curve is upward sloping, with long-term government bond yields significantly higher than the 3.75% policy interest rate. Therefore, in the short term, the cost of reserve financing may be lower than that of long-term government bond financing. However, this is not a permanent advantage; once the shape of the yield curve changes, the cost relationship will also change. Therefore, accounting system adjustments can change the pace of loss occurrence, but cannot eliminate the economic costs left by quantitative easing. The Bank of England has previously clearly stated that the policy interest rate remains the main tool for adjusting the stance of monetary policy, and quantitative tightening should avoid disrupting market operations as much as possible. The scale of active bond sales in the third quarter of 2026 has been clearly controlled, with only short- and medium-term government bond auctions arranged from July to September, and no active sales of long-term bonds arranged. This gives the September decision a dual meaning. On the one hand, the new fiscal year's balance sheet reduction target determines how much existing government bond the central bank releases into the market. On the other hand, the maturity structure of proactive bond sales will overlap with the issuance of new government bonds by the fiscal authorities, affecting the duration risk that the market needs to absorb. Therefore, whether it is £50 billion or £70 billion is not the only variable. The proportion of proactive sales, the scale of redemptions upon maturity, and the weight of long-term government bonds in the sales plan also determine the actual impact of quantitative tightening on the market's supply and demand structure.
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