John Fairhall asked this question on the blog yesterday in response to my post on bond sales feeding off themselves (and I have edited it slightly):
Thanks for the post and the infographics.
I am being extremely dense, so excuse me.
I get that buy a government bond 30 years at 6%, that's a steady fixed rate of interest for 30 years. When it matures I get my money back.
If interest rates go to say 10% on the face of it I should sell and try to buy the 10% government bond.
I may not be able to sell my bond for my cost price ( say £1bn) and make a loss of say £300mn. If this is my only capital is not a sensible strategy. I need to keep my capital. So I sit it out.
What I find difficult grasping is how does the secondary market in government bonds affect interest rates when no new money is being ” created”?
To me it seems to be just “clever financial stuff” that makes a lot of money for the City. With the usual City risk of no one has any idea what is going on and there will be crisis at some point.
Why should the UK issue new government bonds at a higher rate of interest due the secondary market swings, when it can just sit the “game” out?
Has the UK government committed to a policy that is daft?
I have been asked to share my response more widely, as some people thought it was useful. This is what I wrote, although I have expanded one section here to emphasise the choice that the government can make:
You are not being dense. You have asked an important question about the government bond market.
Your understanding of your 30-year bond is correct. If you hold it to maturity, you receive the promised interest and your capital back, assuming the government honours its obligations. What happens to its market price in the meantime need not concern you.
The secondary market is different. Existing bonds are traded between investors, and their prices change according to what buyers are prepared to pay. When prices fall, the yield to someone buying those bonds rises. No new government money is created by that transaction. It is simply a transfer of an existing financial asset.
The problem arises because the government uses secondary-market yields as a benchmark when issuing new bonds. Investors will not normally buy a new bond offering substantially less than they can obtain on an equivalent existing bond. The government is therefore asked to offer higher yields on new issues.
But your final question is the crucial one. Why must the government accept those terms?
The answer is that it does not have to, as a matter of monetary necessity. Government spending creates money. Bond issuance then offers savers an alternative way of holding financial wealth. The government does not need to obtain money from bondholders before it can spend.
The UK has chosen institutional arrangements that link government financing to bond issuance and market pricing. Those arrangements could be changed, although doing so would require decisions about monetary policy, interest rates and inflation management. In particular, the government could decide not to issue bonds when interest rates are too high and borrow from the Bank of England instead, waiting for a more orderly market before issuing bonds again. Technically, nothing stops it from doing that. It does not do so by political choice alone.
So you have identified the fundamental issue. Why should the cost of government financing be dictated by secondary-market transactions when the government is the issuer of the currency in which those bonds are denominated?
That is exactly the question I think we should be asking. The government is not bound by the bond market. Since 1981, when Sir Geoffrey Howe, Thatcher's then Chancellor, introduced the so-called full funding rule, it has chosen to be so, but that decision could be revoked. The question is: why isn't that being done now?
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Of course the government doesn’t have to accept the secondary market price. QE was exactly that – okay, it was the government selling bonds to the BoE, rather than not issuing but it comes to the same thing.
However, QE had implications that we are still pondering…. and a new round of QE would have implications for inflation and FX.
Which ever way you cut it, tax must rise.
And the full funding rule must go.
As should the Bank of England’s independence.
But I think we agree on those.
The key problem it seems to me, in the UK, is the Bank of England’s decision to pay interest on reserves (please excuse me reiterating, somewhat, from an earlier comment).
If the Bank didn’t pay interest on reserves then the treasury could offer bonds at a fixed low rate, say 1%. The Banks would be forced to buy them to get some yield rather than none. Pretty soon this would push down yields overall and defuse the doom loop (which can only occur because of interest on reserves accelerated by Quantitative tightening).
A major problem with the UK economy is the actions of the Bank of England, it’s insurance on raising interest rates to address supply shock inflation and interest on reserves to enforce this perverse policy. These actions are enabled by “independence” of the Bank (thanks Gordon Brown and, oh, thanks so much also for selling British gold reserves at knock down prices. What great ideas) and also enabled by cowardly, supine, governments that refuse to correct this and accept their responsibilities for economic management.
I agree with Clive Parry on this: some reserves do need to be remunerated, but not all.
I think your analysis is incorrect as a result.
We do….. although I prefer QE/QT as the way around the “full funding” rule – the infrastructure is already in place.
I also want, at least as a stepping stone, greater diversity on the BoE board. This is easy to do.
Agreed
I do agree with you and Clive Parry that interest on reserves would be better tiered. I, rightly, had to choose what to say in 300 words. Discussing tiered rates would have breached this limit in a big way.
I don’t agree with Clive’s preference for QE and QT. These are a way of obfuscating the truth, which I think is counterproductive. Furthermore QE has left entirely too much power in the Bank’s hand, giving it the power to sell off gilts, QT, that should rightfully, IMO, have been cancelled rather than sitting in the BoE. I do understand the accounting justification, that the Bank is a separate entity, but it would have been better to avoid QE and achieve the same results, or better, another way.
The full funding rule was explicitly revoked during COVID and the 2008 GFC, proving it is a choice rather than a necessity.
I am not sure I agree. QE maintained the pretence.
Thanks again for incisive information.
Might the ever needed question, “Who benefits?” be relevant here?
Might if be that while politicians, senior civil servants and main stream media journalists “do not buy bonds on a trading platform, their retirement wealth is deeply tied to the performance of the bond market”? (AI Overview)
So if I may add a follow up dense question, is it correct to say that the change in price on the secondary market doesn’t affect the initial coupon rate and so this idea that “government borrowing costs” increase as the yield increases is fallacious?
Yes, you are right about the essential distinction, although there is one qualification.
When a government issues a conventional fixed-rate bond, its coupon is fixed for the life of that bond. If the bond subsequently falls in price on the secondary market, its yield rises, but the government does not pay any more interest on it. The change in yield affects the return received by whoever buys the bond at its new market price, not the government’s existing contractual obligation.
So when commentators suggest that rising yields automatically increase the cost of servicing all outstanding government debt, they are wrong.
The qualification is that higher market yields can affect the terms on which new bonds are issued, or existing bonds are refinanced at maturity. That is why governments that choose to continue issuing bonds may face higher interest costs over time.
But that raises another question: why should a government that creates its own currency be obliged to issue bonds at whatever interest rate financial markets demand?
It is not. Bond issuance is a policy choice, and so is the decision to accept the interest rates demanded by investors.
The important distinction is between the interest the government has already committed to pay, which does not change with secondary market prices, and the interest it might choose to pay on future bond issuance.
Much commentary about government borrowing costs fails to make that distinction.
Richard, the mechanics are right; the conclusion isn’t.
Secondary trading creates no money, and new gilts do price off existing ones. But “borrow from the Bank instead” isn’t a free option. When the Treasury spends via Ways and Means or the Bank buys gilts, banks end up holding extra reserves, and the Bank pays Bank Rate on them. The state hasn’t escaped interest. It has swapped fixed long-term debt for floating overnight debt. That only saves money if Bank Rate stays below the gilt yields being refused. Taxpayers are covering the Bank’s QE losses precisely because that bet went wrong when rates rose.
Nor are long yields just City noise. A 30-year yield largely reflects expected future Bank Rate plus a premium for inflation and fiscal risk. Refusing to issue doesn’t change those expectations. Announcing you’ll bypass markets whenever prices displease you is likely to worsen them, weakening sterling and lifting inflation expectations. An independent Bank would then respond with higher rates. The constraint just moves from gilt yields to inflation and the currency, which MMT itself accepts is the real limit.
John’s “sit it out” logic doesn’t scale either. He can hold to maturity. The government must refinance well over £100bn a year, and many gilt holders (pension LDI funds, insurers, banks) are marked to market. That’s why 2022 spiralled.
If the aim is cheaper funding when long yields are high, the Debt Management Office already has the lever: shift issuance towards shorter gilts and Treasury bills. That carries rate risk, but it’s honest about the trade-off.
Bypassing the bond market doesn’t abolish its verdict, Richard. It just sends the bill somewhere else.
Again, you get things wrong.
There is no legal obligation to pay interest on reserves. I have long argued it should not, at least on their entirety.
You are so wrong.
Richard, agreed: there’s no legal obligation. But it’s a monetary necessity under the current system. With reserves this abundant, stop paying Bank Rate on them and overnight rates collapse towards zero, so the Bank loses its grip on inflation. To regain control it must drain reserves by selling gilts or bills, which pay interest. Tiering is just a tax on banks, passed on to borrowers and savers. Every route still sends the bill somewhere. You’ve moved it, not cancelled it.
You are getting tedious.
Why do Japan and the ECB not pay interest on all reserves?
And, as a matter of fact, interest rates do not control information. Tax does.
You really do need to learn how the economy works before trying to comment again.
Richard, they do pay it, on the reserves that matter.
The ECB stopped paying interest on minimum reserves in 2023, but those are just a 1% requirement. Excess reserves, the great bulk, still earn the deposit rate. The Bank of Japan works the same way: zero on required reserves, the policy rate on excess. That’s tiering, not abolition, and the reason is mechanical. Banks won’t lend overnight below what the central bank pays on the marginal pound. Pay nothing at the margin, with reserves this abundant, and market rates sink towards zero. Both keep paying because they need that floor. The unpaid slice cuts their costs at banks’ expense. The bill moves; it doesn’t vanish.
Japan is also the better warning for your wider argument. When the Bank of Japan capped bond yields, the market’s verdict didn’t disappear. It hit the yen instead, which slid to around 160 to the dollar, forcing costly intervention. The policy was abandoned in 2024.
On inflation: if tax is the real control, name the economy that uses it that way? Every major central bank uses rates, because tax changes need legislation and are slow. That isn’t proof rates work, but “rates don’t control inflation” is an assertion, not evidence.
Telling me to learn economics isn’t an answer. If reserves can go unpaid at no cost, show where the cost goes.
If reserves go unpaid – when they are made by the government and gifted to banks (don’t deny it: that is what happens), the cost is to banks that have been laughing themselves silly about this arrangement since 2009. They will have less profit.
Payment on reserves did not control inflation prior to 2009. Tax did. It still does, here in the UK. It’s so effective you do not notice. In fact, it is the primary purpose of tax since it does not, and never can, fund government spending. You really do have a lot to learn.
Neil is correct to say that not paying interest on gilts is merely substituted by interest on reserves. But you are correct to say that the BoE does not have to pay interest on reserves. The key is to find a regime that reduces interest costs but maintains transmission of policy rates to the real economy.
There is no simple answer to the question – indeed nobody really knows in detail the best way to do it. My suggestion is an incremental increase in the level of unremunerated reserves for all balance sheet size. Start small and increase slowly. We will probably discover all sorts of issues but go gently and adapt as we go.
Clearers will hate it but it should be put as “the price of no windfall taxes”.
Accepted.
It is possible to do; that is the key point.
Neil is also correct that tax, while it does control inflation is slow….. but so is monetary policy.
My belief is that a blend of tax and interest rates is the right approach…. which requires better HMT-BoE coordination.
I would describe the impact of taxes as immediate. It works so well that you do not notice it. Look at the 2010s
Thank you Richard. I’m in agreement. The secondary bond market is about financial speculation. The “interest” on existing goverment debt (e.g. yields at issuance) do not change. Rather it pushes up the “interest” on future government bonds. As you say, there is no necessity for tbe UK government to issue bonds, as it can “borrow” from itself.
But Bailey is now making it the priority.
Agreed.
My answer to your final question : reflexive fear of hyperinflation from politicians and the general public that don’t (yet) understand MMT. Politicians that do understand are in the minority and likely afraid of major pushback. So we need to keep going like a broken record with the messaging that defecit spending to purchase the real resources (including labour) currently sitting idle (and put them to work in creating or enabling fresh supply) will not drive inflation. Hopefully it will cut through eventually. Real case studies may also help soothe some of the anxiety e.g. Bank of Canada direct financing 1945-1974. No hyperinflation there.
Agreed
Well done John & Richard.
I was not aware of what Howe did in 1981. I was questioning this in my post too.
So to me, looking at this with new eyes, this is essentially a form of privatization in my view. However, what is extraordinary is that this is essentially the privatization of a sovereign money supply. There is nothing natural about this, when one considers the history of money – Howe committed an ahistorical act.
Let’s be clear here: Power has been ceded to a market in the name of ideology.
As far as I am concerned, Thatchers’ government committed a seditious act against it own state, it’s own democracy. ‘The enemy within’ was her.
You have spoken a lot about choices Richard, and now – learning this – your point hits home hard. We have been betrayed – it’s as simple as that for me. They’ve essentially given away the whole ranch.
The ‘Full Funding Rule’. What an abuse of language. What an abuse of power. And New Labour got into power and did not rescind it? And Starmer tolerated it? Burnham?
Honestly, I’ve never pretended to know everything but I’m past angry about this. And please don’t anyone mention bollocks like ‘market/debt discipline’ or anything like that.
We been taken for mugs, the lot of us. And I don’t like that at all.
Much to agree with
This post today reminds why I keep coming here.
We’ve been denied this information from elsewhere for years and years, and because of political complicity. It also shows how Thatcherism still towers over this country, like how Nazism still defines the countries of Europe and what happens in the Middle East to this day.
We need truth and reconciliation commissions everywhere!
If taxes have to rise, then whose taxes will it be? Could we have a financial transaction tax on the City? They’ll be making enough money out of it won’t they? Why not tax the wealth that has been accumulating, rather that that which is shrinking?
‘Deficit spending’ – oh Christ – look – it’s government investment. What we are lacking isn’t it? Why do we insist on portraying this as though it causes a problem? The language is all wrong.
Agreed, and thank you.
Wasnt there some sort of change in the way Government Bonds were sold so Government went from being a price maker to a price taker?
Effectively, the full funding rule did that.
Although QE can act as a workaround if required (it’s no longer required for the UK as we’re no longer in the EU)
It is not required and caused considerable harm
Right up until 1995 gilt issuance was handled by the BoE who took an opportunistic approach to selling bonds. I rather liked the uncertainty of that approach. However, the powers that be were persuaded that complete transparency would, overall, cut the cost of borrowing. Maybe, but it does allow the traders/speculators the chance to frontrun the big “forced/announced” seller.
Agreed
You would have thought that one of the Labour Chancellors, since Geoffrey Howe introduced the full funding rule in1981, would have thought to revoke it. I guess they weren’t very bright 🙁 . Sir Geoffrey must be laughing in his grave.
Agreed
Since Brown Labour has been terrified by being labelled big spenders. Badenoch shouted it out this week.
The obvious answer is Yes because we have to spend money to rescue our society from the Tory robber barons.
Agreed
I realise there are some commenters here with real experience of the bond markets, and I may have posted this link before, but I found Simon Wren Lewis’s comments on the bond market insightful: https://mainlymacro.blogspot.com/2026/06/why-governments-are-not-in-hock-to-bond.html
I agree with quite a lot of that, but not all. His argument embraces MMT, but he does not reach the logical conclusions. But overall, the direction is sound.
Is Neil Standring right to say that Japan and the ECB do pay interest on the great bulk of reserves?
It depends on what they deem essential reserves.
Not sure about Japan but I think roughly EUR 200bn is unremunerated or about 10% of the total ( 90% being remunerated at the deposit rate of 2.5%).
So, the 200bn at zero is saving EUR 5bn. Perhaps they could increase it to 400bn and save a further 5bn??
In the UK total reserves are about GBP 650, I think so if £150bn was unremunerated it would save £5bn. Not a small amount and something that would not threaten the stability or smooth running of the banking system.