Yesterday saw a change in the operation of UK monetary policy as the new Governor of the Bank of England made his mark on it. In essence he took us back to one of the earliest themes of this blog which was that monetary stimulus would follow the “More,More,More” path a bit like a junkie forever needing a new fix. Those in charge of UK monetary policy have spent the following 3 and a half years confirming that theme. However yesterday’s move had several nuances and ended up with not a few contradictions.
Where’s the beef Mark?
If we look at the promise expressed below there is an immediate issue.
the MPC intends not to raise Bank Rate from its current level of 0.5%
Hands up who thought that the nine members who currently make up the Bank of England Monetary Policy Committee (MPC) had any intention of raising interest rates? This year? Next? On that basis it rapidly becomes clear that we are seeing an example of “open mouth operations as an institution that does not intend to do something anyway says that it won’t!
So there is an element of an emperor with no clothes here.
UK monetary policy tightened yesterday
Not perhaps the paragraph heading you or indeed Mark Carney were expecting! Let me explain by showing what happened in UK financial markets.
Before the announcement UK interest rate futures ( a past stomping ground of yours truly called short sterling confusingly) surged as large bets were placed that something involving a substantial easing of monetary policy was about to take place. At that point monetary policy had in effect been eased before anything had happened as the power of expectations took hold. Briefly on the announcement the pound’s exchange rate dropped around a cent versus the US Dollar to US $1.52. At that point the UK was pricing in an easing of monetary policy.
Unfortunately for Mark Carney and his eight colleagues on the MPC this lasted for only seconds. The briefest ever easing of UK monetary policy? Perhaps. As the details of his plan emerged UK interest rate futures plunged and the pound’s exchange rate shot higher. If we look at the contract for June 2016 which had closed at 98.42 the day before those who thought that they had the “early wire” pushed it up to 98.56 before the announcement but afterwards it plunged to 98.24. At that point UK interest rate expectations had risen by a quarter point compared to the pre announcement frenzy.
Next we move to the pounds exchange rate which soared from the depths of 1.52 to the heights of 1.55 against the US Dollar. If sustained this represents quite a form of monetary tightening itself and the Bank of England used to regard a 4% change in the pound’s trade-weighted index as a 1% change in interest rates. These days you would need thumbscrews and wield a dentists drill in the manner of Laurence Olivier in the film Marathon Man to get such a confession out of them. However any sustained move by the pound to this level would have a clear anti-inflationary effect. Just as an illustration a barrel of Brent Crude Oil became £1.40 cheaper as a result of the move. Also we did not only rally against the US Dollar as we also pushed above 1.16 versus the Euro.
Matters are always entwined and the rally in the pound helped UK interest rate futures to rally too. However if we take the net impact of the too we see that lower interest rate futures and a surging pound meant that UK monetary policy had just tightened.
Was this a surprise to some?
There are plenty of economists and analysts around who treat central banks are like some form of Superman or Wonder Woman. They either do not know or ignore the fact that central banks only control the overnight interest rate (maybe up to a month if we are feeling generous) and in spite of their attempts to impose a type of command economy on us they do not control bond yields or longer-term interest-rates.
Meanwhile back in reality
The experience of the United States had given us a clear example and indeed template. It started down this road on the 12th of December 2012 and since then US bond yields and mortgage rates have surged. For example the US ten-year Treasury Bond yield has risen from 1.6% to 2.6% over the intervening 7 plus months.
So the response in the UK should not have been a surprise and we wait to see if the American response pattern is repeated. As ever there are complications as our markets also responded to the US changes so we have a tangled web to untwine.
Of Expectations and Psychology
If we go deeper we are left with a dark question which is as follows. If the concept of “forward guidance” did not exist would implied interest-rates and bond yields now be lower?
At this point the omnipotent Superman shrinks to Clark Kent.
Some may have wondered if forward guidance was a way of laying a smokescreen for the reversal of policies such as Quantitative Easing. Apparently not in the UK.
the MPC intends not to reduce the stock of asset purchases financed by the issuance of central bank reserves and, consistent with that, intends to reinvest the cash flows associated with all maturing gilts held in the Asset Purchase Facility.
As the UK government is now benefitting from these cash flows there will be enormous pressure from it for this state of play to continue. I would say that this was another nail in the coffin for Bank of England independence but there is now no room on the lid for an extra one!
The Evans rule
In essence the UK is copying the policy of Federal Reserve member Charles Evans by setting an employment target and loosening its inflation target. It was not an exact copy as otherwise people might have started wonder why we were paying a man £874,000 a year to copy and paste the American policy! So we ended up with a 7% unemployment target rather than 6.5%.
Flaws with targeting the unemployment rate
There are sadly quite a few as it varies with factors such as size of the labour force and participation rates which means that changes can be misleading. It also does not deal with concepts such as underemployment and completely ignores the issue of zero hours contracts which I discussed only on Monday.
What does this achieve anyway?
Let us say that Mark Carney achieves his objective and the base rate stays at 0.5% for the next three years for example. What happens? Yet again we see that the banks are the winners as they can get funding at this rate from the Bank of England, but what about us?
If we look at the Bank of England’s effective interest-rates page we see the following
mortgage rates 3.33%
unsecured borrowing 7.72%
credit cards 10.52%
None of them look very near to 0.5% to me. Although when discussing this point yesterday on twitter there was a reply that savers might get 0.5%….
The UK inflation target has shuffled upwards to 2.5%
in the MPC’s view, it is more likely than not, that CPI inflation 18 to 24 months ahead will be 0.5 percentage points or more above the 2% target
This was presented as a knockout to the policy at which point it is hard not to laugh. Notice that it is a forecast? Even when inflation went above 5% the Bank of England forecasts were for 2% inflation. Those worried about possible inflationary issues may note that the Bank of England is weakening its ground in this area although some caution is needed as it has not taken any notice of it for some years now.
medium-term inflation expectations no longer remain sufficiently well anchored;
Actually the Bank of England’s own survey shows that they are not well anchored at all as shown below.
Median expectations of the rate of inflation over the coming year were 3.6%, the same as in February.
Asked about expectations of inflation in the longer term, say in five years time, respondents gave a median answer of 3.6%,
Mark Carney was asked about this in the press conference by David Smith and was very dismissive. So the chances of this ever landing a knock-out blow are not far off zero.
Looking at the situation after Mark Carney’s forward guidance has been introduced we see that we have entered another stage of monetary policy. The whole concept of “open mouth operations” leaves us with the thought that monetary policy may be a lot nearer to being “maxxed out” than they would like us to believe. If we use the American phrase “Where’s the beef?” we see that in effect we are seeing a continuation of the same policy.
So Mark Carney tells us that he is moving monetary policy in a more expansionary direction but compared to his predecessor is he really? Indeed when we ask what has he done the waters get very murky as I have discussed above. But as we look at his and the other eight members of the MPC’s influence I am reminded of my campaign in this area.
My suggestion for much needed reform at the Bank of England
I have a policy recommendation and it does indicate quite a change. As the role of the Monetary Policy Committee has changed and expanded more than could have been forecast when it was introduced back in 1997 there now needs to be new checks and balances on its power. My suggestion for a change is that MPC members should stand for election as they are currently much more powerful than many of our elected representatives.