22 June 2017
A Tale Of Two Committees
Should the Fed and the Bank of England swap strategies?
by Frank O’Nomics.
The 1980’s comedy about a tabloid newspaper, Hot Metal, once had an episode where the editorial team agonised over a lack of subscriptions when producing headlines like “Pound has a quiet day on the money markets”. On the face of it, writing about last week’s widely predicted central bank activity might seem to have the same level of interest – but please bear with me. While the Fed raised US interest rates by 0.25% to 1.25% and the Bank of England kept UK rates at 0.25%, as predicted by pretty well every economic commentator, these moves look at odds with the economic data being released. Indeed, if you just look at the inflation numbers (and inflation targeting is the focus of most central bank policies), it is the Fed that should have done nothing and the UK that should have responded. We need to ask whether the Fed is stuck on a pre-announced course that it struggles to turn back from, and whether the Bank of England has become bogged down in inertia.
Taking the US situation first. Not only did the Fed announce a 0.25% rise in its funds rate, but it also pointed to a further rise later in the year and announced plans to unwind the $4.5trn of assets acquired through the process of quantitative easing. This stance runs entirely contrary to the latest economic data releases. Inflation is falling in the US, with CPI last week reported at 1.9%y/y in May, down from 2.2%. Core inflation is even lower, with CPI excluding food and energy running at 1.7% (down from 1.9%). Other indicators also show a slowing economy, with retail sales down 0.3% on the month, when a rise of 0.1% had been expected. Why then, given a 2% CPI target, has the Fed decided to carry-on regardless?
There are a number of reasons. Firstly, there is an inclination to look through short-term data, with some seeing inflation as subdued for structural and technical reasons. Labour market data appears to support such as stance, with the uninterrupted fall in unemployment from its 10% peak in 2009, to its current level of 4.3%. There is inevitably some concern over the extent to which the policy of low interest rates has inflated the value of most asset classes to a point where there is a renewed threat to financial stability if the bubble bursts. While other nations seem intent on adding to the pressure (Russia cut rates this week), the Fed is trying to gently undermine the bull market. Perhaps more significantly, the Fed seems keen to get rates up, and to reduce its balance sheet, so that if the economy does take another lurch down they have built up a reasonable level of ammunition to ease the pain. If the danger of deflation is currently seen as minimal, a return to a more normal level of interest rates would appear to have a limited risk. The Fed regards 2% inflation as being most consistent with their mandate of achieving price stability and maximum employment over the longer run (although the Fed Governor Janet Yellen has been encouraging a debate over the possibility of raising that target), but they do not have to respond to short-term deviations from this target.
The Bank of England’s inertia may be a little harder to justify. They too have a 2% inflation target, but the weakness in sterling meant that the latest CPI data here hit a four-year high of 2.9%y/y, well ahead of expectations and above the peak that the Bank had warned we would hit. The Bank has encouraged us to look through what they regard as a short-term phenomenon, and the level of average earning has been slipping in the last few months to suggest that, at present, a spiral is not developing. However, the logic regarding asset prices would seem to be as well justified here as in the US. Low interest rates are encouraging the build-up of household debt to unprecedented levels, and the ongoing reinvestment of the Bank’s £445bn balance sheet, developed via quantitative easing, has pushed bond and equity prices to levels that leave a high risk of a destabilising sharp correction at some stage. As in the US, creating some latitude to help the economy, when and if a correction does come, makes a lot of sense. Such arguments seem to be winning over elements of the Monetary Policy Committee, with 3 (of the current total of 8) voting for a 0.25% increase last week. However, one of the 3 dissenters (Kristin Forbes) is stepping down from the committee, to be replaced by an academic, Professor Silvana Tenreyro. It is rare for new MPC members to go against the consensus and Prof Tenreyro’s background suggests she will be more dovish than Ms Forbes. The Bank’s Governor, Mark Carney, in a speech this week, said that he wanted to see how the economy reacts to Brexit negotiations – and, given the long timetable envisaged, such an approach probably makes it a little premature to expect a rate rise in the very near future.
What do markets think of all this? Well, the US bond market does not expect the Fed to be able to follow-through on its rate rise initiative, pricing a less than 50% chance of a further increase this year, and 10 year inflation expectations are currently near a 7 year low (at 1.7%). The Bank of England’s current stance, however, does seem to be accepted by the gilt market, where 2 year bonds yield just 0.17%, and even 10 year bonds offer little more than 1%. However, markets are not always right and, if we look just at the data, the danger is less that it stays the hand of the Fed, and more that it encourages a reaction from the Bank of England.
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