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Netwealth oped: A litany of mistakes – modern day UK monetary policy

Nov 4, 2022

This article first appeared on Netwealth – 04th November 2022.

UK monetary policy leaves much to be desired – and we should examine the reasons why. The last week has seen both the US Federal Reserve and the Bank of England raise policy rates by 0.75%. There, however, the similarity ends.

For some time, the Fed has been seen by the market as being ahead of the curve, keen to get on top of inflation. Furthermore, it followed its decision to raise the Fed funds rate to 4% this week with a clear, hard-line message at its press conference by Fed Chairman Jerome Powell. While the Fed statement to accompany its decision was balanced, reflecting an unanimous agreement to hike, Powell’s press conference pulled no punches.

Inflation is still high and while it is likely to subside next year the Fed is not taking any chances. Their bias is still to tighten. The underlying message was that recent market talk of a pivot towards easing, or the end of this tightening cycle, is premature.

The US labour market is tight. Wages may be creeping higher. Firms are boosting prices – either to pass on higher costs or to raise profit margins, or both. The Fed has a bias to tighten because their fear is inflation may become embedded. In recent weeks, there has been greater discussion in the market of how history has shown that if central banks don’t act then inflation can prove hard to reduce. The UK’s experience in the 1970s is testimony to that. The Fed is clearly on top of market thinking.

It is, of course, the Fed that helps set the tone for global markets. It is indicative of the continued global tightening in monetary policy, although there are a few significant differences – notably China where monetary policy was prudent during the pandemic and could ease further now, to accompany post-covid unlocking, and in Japan where rates are low and the yen is weak, although the latter has now triggered currency intervention.

These exceptions apart, globally we are witnessing the end of cheap money. And the market expects the Fed to continue to lead the way, hiking until next summer. Powell did nothing to dissuade such market thinking.

In contrast, the Bank of England’s messaging was far from clear. Unlike the Fed, the Bank has been seen by the market to be behind the curve. This is despite this being the eighth successive policy meeting at which UK policy rates have risen. Indeed, often overlooked in recent UK analysis, has been that a significant part of the risk premium attached to UK assets over the last month was because of the fear that policy (both monetary and in the wake of the ill-fated mini-Budget, fiscal policy too) was stoking inflation.

It was not just the affordability of fiscal policy changes, but the inflation outlook that worried the market and a lack of confidence in whether the Bank is up to tackling inflation. The market felt then that UK monetary policy was not doing enough and that fiscal policy, through its mini-Budget easing, was pulling in the opposite direction.

Now, the picture is different. Monetary policy has been tightened further and fiscal policy is being tightened, with much of the mini-Budget being reversed and further tightening now being signalled for November 17th.

This week the Bank hiked interest rates by 0.75% to 3%. Then, in contrast to the Fed, it played down future expectations. At the press conference the message was that the path for rates was unlikely to be as aggressive as the market was currently discounting. Those market expectations were for policy rates to peak at 5.25%, which was where they were at the time the Bank was putting its Monetary Policy Report and forecasts to bed last week.

Now, the market expects rates to peak at 4.75%. But the Bank showed this would lead to inflation undershooting significantly its inflation target in the future. Indeed, the underlying message was that the rate outlook was more likely to be closer to the trajectory where rates stayed constant. In that trajectory of constant rates the Bank expects a shallower recession than if rates rose in line with the market’s thinking – but it still expects a recession.

But it was not just the fact that the Bank hiked aggressively and then hinted at a future dovish rate outlook. I find the Bank’s analysis is all over the place. It is not just how they say it in terms of communicating with the market, an uncontroversial and longstanding issue, it is what they do and why they do it.

The Bank expects a two-year recession. This is far more pessimistic than other forecasts. They also expect unemployment to rise sharply, to over 6%. The Bank’s economic forecast is also based on an assumption of a continuation of the energy price cap after it is scheduled to end this spring (although this continuation is not expected to be as generous as it is now, they do not specify what type of extension they have assumed).

Also, the Bank has not factored in a further tightening of fiscal policy this November, although this has been widely signalled in advance by the Chancellor. Thus, non-monetary policy may yet prove to be tougher than the Bank is currently expecting. The Bank, on unchanged rates, assumes inflation to return to target. It always does.

This prompts the immediate question, if you think inflation is about to subside and the economy is about to have a two-year recession, why do you tighten monetary policy now? Yes, there are many forecasters who may be saying monetary policy may need to tighten, including having higher rates, but none, if any, are saying the recession will last for another twenty months – as the Bank of England does.

The Bank also seems to take ownership of inflation when it expects it to decelerate, but not when it has risen. Currently, consumer price inflation is 10.1%, well above the 2% inflation target. The Bank stated: “Higher energy prices are one of the main reasons for this. Russia’s invasion of Ukraine has led to more large increases in the price of gas.”

Yet, when Russia invaded Ukraine in late February, UK inflation was already high and rising. Consumer price inflation reached 6.2% and retail price inflation was 8.2% in February. Higher energy prices have certainly not helped, but they were not the only factor in inflation being way above target.

I have previously talked about two wrongs not making a right. The first wrong being that the Bank eased policy last year when it should have been tightened, and the second wrong being that it was likely to tighten too much now when the economy is unable to cope.

Take, for the moment, that first wrong: the Bank was very slow to act last year to tighten policy and to nip inflation in the bud. At the start of 2021 inflation was only 0.4%, and the economy looked set to rebound solidly – as it did – as it emerged from the pandemic. The economy could have coped with policy tightening.

Instead, there was further significant easing, through Quantitative Easing (QE), which exacerbated the inflation outlook. At that time we asked which ‘P’ was the rise in inflation likely to be: pass-through, persistent or be permanent. The Bank wrongly thought it would pass-through quickly, whereas correctly we felt it would persist. It is this high inflation that is now a major problem for the economy.

The Bank is independent, but last year – when it engaged in QE – it did not behave as an independent central bank. It was dependent. In buying government debt at that time it effectively allowed the Government to engage in fiscal easing. It wasn’t necessary for the Bank to print £450 billion. The Government then could have borrowed a significant part of this in the markets, when borrowing rates were around zero, and even for a longer term, when there was a huge appetite globally for government debt at that time. In the event the Bank now owns close to one-third of the national debt.

In a paper delivered last week, in a monetary conference at the Institute of International Monetary Research, former MPC member Charles Goodhart (of the Financial Markets Group) demonstrated how the Bank had misread the type of shock the economy had received and because QE had worked after the global financial crisis, it wrongly thought it would work because of the pandemic.

At the same conference, economists John Greenwood (of International Monetary Monitor) and James Ferguson (of MacroStrategy) in separate papers showed how the surge in QE had translated into a surge in broad money growth, feeding higher inflation. As Greenwood pointed out, the Bank, like the Fed, buys most of the securities in its asset purchase programme from non-banks, not banks, unlike the ECB or BOJ, thus creating new money.

The inflation tail from this, because of the lagged impact, will be seen this year and next. But monetary growth is now slowing.

I am not a monetarist, but naturally I take account of monetary data in my reading of the economy. The Bank though, seems oblivious to such criticism and to addressing it. As I have pointed out before, bizarrely monetary analysis does not figure in their reading of the economy. Money and monetary growth is never mentioned in their quarterly Monetary Policy Report. They do mention financial conditions, but this is not the same.

The relation between monetary and fiscal policy is, naturally, key. We are now seeing fiscal policy being tightened. This will take the pressure, it seems, off the Bank. This fits with rates not needing to peak so high in this cycle. However, the UK is the only major economy to be raising taxes going into a recession. Further tightening is expected because of the so-called fiscal ‘black hole’ in the public finances.

In the US, the Government relaxed fiscal policy this year but that was overlooked by the market, as the Fed was tightening significantly and messaging it appropriately. The fact that the nature of our inflation shock was driven by energy and supply-side factors and exacerbated by inappropriate Bank of England actions last year and lax monetary growth, and crucially not by an overheating domestic economy, could have allowed for some fiscal stabilisation.

Ironically, this is now the argument being used by critics of the impending austerity. But as we have addressed previously this was mishandled in the mini-Budget. The UK’s ratio of debt to GDP is manageable, but it is high and thus leaves its outlook very sensitive to the relationship between future growth and interest rates.

A recession will hit the public finances hard, and push the ratio of debt to GDP up in the next couple of years. Far better to avoid such a recession, by not hiking taxes. This might have pushed the ratio of debt to GDP up for the next two years, and hence the vital need to show that the outlook was then for debt to GDP to then fall. This has now been replaced by the likelihood of higher taxes and curbing spending to keep debt to GDP low.

But a recession is inevitable and this is the price now to bring inflation lower. The challenge, however, is that even though inflation will decelerate next year, it is still unclear where it will settle. As mentioned before, it may be nearer three to four percent rather than the one to two percent we witnessed pre-pandemic.

A pro-growth strategy requires a triple arrow approach of: supply-side reform focused on investment, innovation, infrastructure and incentives; credible fiscal policy with a clear trajectory to reduce debt to GDP (and where a government invests for growth and not engage in austerity and spending cuts when the economy is going into a recession); and the final arrow of monetary and financial stability.

Lord Macpherson, the former top civil servant at the Treasury, in a speech this week in Edinburgh stated that “the key to long-term growth is the supply-side of the economy”, before crucially adding that “it’s also necessary to have a tax and regulatory system which encourages enterprise”. The point being that fiscal policy must be used actively to help stimulate growth and that incentives matter.

As I’ve also repeatedly stressed the UK economy has become accustomed to cheap money for too long, and as we are now seeing it is vulnerable to higher rates, even when they do not rise too far.

As I wrote in The Guardian in December 2021: “Low interest rates mean financial markets don’t price properly for risk. This encourages speculative behaviour, which is exacerbated by the scale of QE.”

The problems with the pension funds last month were a problem waiting to happen – and which the Bank and the regulators were aware of – and are a warning of what might be seen if rates were to rise too far, too soon. We are already seeing the end of cheap money. But the speed, scale of sequencing of future tightening needs to be sensitive to how the economy and financial markets will cope.