By Tony Yates
The MPC have now started deliberating about their next decision on interest rates and asset purchases.
The outlook for the UK economy post Brexit is not great, but not yet as bad as it could have been.
We already have evidence of some fall in consumer and business confidence after the referendum result. And there is an anecdotal evidence of cancelled investment projects and an interregnum the housing market. The sharp fall in the pound and the fall in the stock indices like the FSTE250 and others that include more domestically oriented firms gives us the markets’ negative and predictable judgement about the situation.
The fall in the pound/stocks comprises several things. The expectation of looser monetary policy for longer; the distaste for the extra uncertainty in the UK at the moment; and the expectation of lower income per head in the medium to longer term.
Although looser monetary policy for longer doesn’t necessarily mean a cut in rates below what had previously been established as the floor of 0.5%, my guess is that this is what will happen, and what is needed. Indeed, I thought that a cut would have been warranted as an emergency precautionary step in the aftermath of the referendum. The cut would come in advance of much hard evidence that the economy has weakened, but it would echo the precautionary step the Financial Policy Committee have taken in lowering the cyclical capital buffers for banks, which has also come in advance of hard evidence about the state of the cycle. Even without the guess that demand has fallen/will fall, looser monetary policy would follow from the motive close to the zero bound to rates to loosen [to minimise the chance of losing control of monetary policy in the event that the central expectation of the outlook proves overly optimistic].
A cut would resolve the uncertainty that the BoE described about the appropriate response of policy. Recall that the May Inflation Report analysis described that this response was ambiguous, since there are offsetting supply side and exchange rate effects pushing up on inflation. I doubted that the BoE really were uncertain about what they would do, and markets seemingly share this view. Probably that uncertainty derived from a general central bank reluctance to appear to engage in commitments to courses of action, or less charitably, to the desire not to complicate statements by the Chancellor to the effect that mortgage rates might rise post Brexit.
Some, like Vlieghe, have also drawn attention to the fact that asset purchases are not ideal substitutes for rate cuts.
Will the BoE will go to 0.25pp or even lower, and will they engage in further asset purchases? My guess is that they will stop at 0.25pp, but signal that this would be in place for some time, and that there would be no further asset purchases. Although MPC have signalled that 0.5% is no longer the floor to rates, they have also continued to rehearse the arguments that at some point rates hurt retail bank and building society balance sheets (roughly, because while loan rates track Bank rate, deposit rates can’t fall). And those arguments are thrown into sharper relief by the fall in bank shares in the UK. And Carney’s revealed preference is to avoid them: he has preferred to allow the disappointments in the outlook for inflation to lead to corresponding changes in the expected time at which interest rates rise, rather than to push for further asset purchases. And in the run up to his appointment to his Governorship, when the initial push for forward guidance was motivated by a clear desire and need for further monetary stimulus, he was pretty clear that this should happen by signalling about future rates rather than further QE. [By the time he had arrived, the case for a loosening had weakened, of course, even though forward guidance was implemented anyway, for motives linked to eliminating uncertainty about rates, rather than loosening policy].
I started out by saying that the outlook was not as bad as it could have been. That said, there are some worrying things to watch, like the fall in bank shares already mentioned; the problems in Italian banks, which could, in combination with difficulties orchestrating a good response from the Eurozone authorities, spark more generalised difficulties in financial markets; the small increase in the spread between Bank Rate and LIBOR; and the stops on redemption in funds invested in commercial property. None of these ought to be critical for financial stability. But that is the sort of thing I used to write in memos in the Bank of England when the first data that were to lead to the 2008/9 crisis emerged.
Tony Yates is professor of Economics at University of Birmingham and teaches International Macro.