21 July 2016
Tantric Central Banking
Dithering over rate moves hides a fundamental impotence.
by Frank O’Nomics
Yet again the Governor of the Bank of England has strongly hinted at a change to monetary policy and has failed to follow-through. Following at least 3 occasions when he seemed to be preparing markets for an interest rate rise, this time Mark Carney warned them that, post-Brexit, an easing of monetary policy would, most likely, be needed this summer. Despite markets having priced in a 90% chance of a rate cut last week, with 39 out of 60 economists polled by Reuters also predicting a move, the Bank of England Monetary Policy Committee decided to do nothing.
Admittedly, the majority of the MPC did expect that they would need to act next month, once further information was available, but this is an excuse that can always be used, Beyond August we will still have the huge uncertainties surrounding Brexit negotiations and the US election for example. There is of course some sense in waiting for the publication of the Inflation Report next month as this is the occasion when official economic forecasts are updated, and by then the extreme initial reactions to the Brexit vote, most notably the fall in consumer confidence, may well have moderated. However, there may be something more significant going on here – namely that, whatever the Governor thinks needs to happen, most elements of the situation are way beyond his control, and the use of monetary policy to effect an economic stimulus has no further scope.
The Bank has hinted at a package of measures being introduced next month and this may itself be an acknowledgement that those used so far have either run their course of being effective, or have failed to be so. The use of interest rates has long been the primary means of trying to generate a stimulus, but we are very close to the lower bound, unless negative rates are to be introduced – and the MPC is worried about the possible consequences of that. The additional lending or investment that can be generated by cutting rates by a further 0.25 or 0.5% is likely to be infinitesimal. Sub-1% yields on 10 year gilts have failed to stimulate investment – it is not high rates that are restricting investment, but high uncertainty. Similarly, the potential impact of further quantitative easing seems to be very limited. The Bank has already purchased £375 billion of gilts and all this has served to do is further inflate the value of property prices and the gilt market – creating the twin evils of making housing even less affordable and pensions less remunerative (by reducing long-term interest rates). Theresa May has already expressed concerns about exacerbating these problems. The Bank could move towards targeting purchases of corporate bonds (as has the ECB) but the consequences are likely to be exactly the same.
What else can the Bank do? They have talked of introducing a “package of measures” and have already taken steps to help the commercial banking sector by relaxing capital requirements on lenders, which effectively gives them a further £5.7 billion of headroom to absorb losses without reducing lending. They have also mentioned the prospect of extending the Funding for Lending Scheme which, since 2012, has delivered £58 billion of cheap funding to banks for on-lending to small businesses and households. This too would make sense, but the creation of cheap supply does not solve the problem of limited demand.
Perhaps the best suggestion seen recently is that of shifting the maturity of the Bank’s current holdings of gilts bought under QE. If they were to sell the longer-dated paper to buy 2-3 year gilts this would have the combined effect of reducing short-dated yields, which are used to set fixed mortgage rates, and increase longer yields. The latter effect would be very beneficial to the banking sector (who borrow short and lend long) and would provide some much needed respite to the pensions industry by reducing the pressure on annuity rates.
Not all of the MPC members are pre-committing to a rate cut. Martin Weale (who is soon to leave the committee) said , “For there to be a case for easing policy I will need to expect weakness in output to be large enough to compensate for any overshoot in inflation”. Further, there are still plenty of other voices, mostly those of the IEA, Shadow MPC and Economists for Brexit, who would argue that nothing of note really needs to be done to monetary policy. Some argue that the hit to consumer confidence was not as great as previous economic shocks and will not necessarily translate into a slowdown in household spending. Others, notably Patrick Minford, see the benefits of life outside of Europe (subject to us declaring unilateral free trade) providing an additional £40 per week to the average household, which is equivalent to a large tax cut to help economic growth. If nothing else there is undoubtedly some value in Gerard Lyons’s (former economic advisor to the Major of London) assertion that there is nothing to be gained by the Bank and the Treasury continuing to talk down the economy, as this risks “the danger of a self-fulfilling downward spiral”.
It may well be that the key information awaited is the policies to be adopted by the new Chancellor of the Exchequer, Philip Hammond. The Bank of England is supposed to be independent, but their actions will not be taken regardless of what Mr Hammond decides to do with fiscal policy, and there is eminent sense in their coordinating policy. The Chancellor has pledged to work with the Bank over the summer to “make some carefully considered decisions to boost confidence among households and businesses”. He has further vowed to take whatever measures” are needed to “stabilise the economy”. Some might take this as an acknowledgement that he believes that the Bank of England has done as much as it can. A move away from austerity measures and a drive to borrow to invest (please see last week’s article) seems likely.
There has been much outcry in the City along the lines of “if they are convinced that they will need to do something why have they not acted already?”, and the one member of the MPC who is emerging with some credibility in this respect is Gertjan Vlieghe, who was the sole vote for a rate cut this month. However, it seems that the reasons for delay go beyond just needing more information. There is a much more deep-seated issue that suggests that circumstances have moved beyond the Bank’s remit, and they are not (as Capital Economics have suggested) dithering, but are instead redundant. Still, it seems very likely that we will get a package of measures from the Bank in August (including a rate cut). The Bank’s Chief Economist, Andy Haldane (an MPC member), has said that he is almost certain to vote for a large monetary easing next month, and that he “would rather run the risk of taking a sledgehammer to crack a nut than taking a miniature rock hammer to tunnel my way out of prison”. Others will be concerned by the additional damage that sledgehammer might do and may feel that the real remedies are more likely to come from Mr Hammond in November’s Autumn Statement.
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